Money, inflation, and central banks

Milton Friedman famously declared that inflation is always and everywhere a monetary phenomenon.  While that no doubt remains a universal principle, it is not the same (as some people think) that inflation is a central bank phenomenon.  Certainly, before central banks were created by governments there was inflation when Spanish galleons returned from the new world loaded with gold and silver, and when prospectors discovered huge amounts of gold in California. Nevertheless, in the past century of central banks it has become common to believe (mistakenly) that because central banks (once had) control of the amount of money in circulation, they have the power to control inflation.  For a variety of reasons (explained in some detail in my recent paper for the Cato Monetary Conference), the unintended consequence of “Quantitative Easing” (also referred to as Large Scale Asset Purchases) has been that some central banks have sacrificed their tools of monetary control in favor of credit/capital allocation policies. The essential conclusions of my Cato paper are: For several years, major central banks have pronounced that the objective of massive QE or LSAP is/was to raise the inflation rate. That objective has not been achieved in spite of quadrupling of the central bank balance sheet (in the case of the US). Because commercial banks are no longer reserve constrained, the historical linkage between the central bank's balance sheet (monetary base) and outstanding money supply has been broken. Changes in the size and composition of the central bank’s assets and liabilities are unrelated to the amount of money in circulation. Without the ability to influence the supply of money, central bank open market operations have no influence on the rate of inflation. Announced changes in the overnight interbank rate target (Federal funds) have no implications for the thrust of policy actions on economic activity or the rate of inflation. If inflation should emerge, central banks have no tools for countering the pace at which the purchasing power of money declines. In the early stages of past periods of accelerating inflation, central banks mistakenly expanded their balance sheets as they “leaned against” the rising trend of nominal interest rates as an “inflation premium” was being incorporated by both lenders and borrowers. That is, policy actions of monetary authorities were “accommodative” of the rising trend of prices. For the foreseeable future, no such accommodation will be necessary. The ballooning of central bank balance sheets has been more than sufficient to fuel extreme rates of inflation without further debt monetization. This is not a forecast that inflation will in fact occur. It simply is a statement of the new reality: whether or not there is inflation is unrelated to anything central banks do or do not do.

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Jerry L. Jordan, PhD

Jerry L. Jordan is a Senior Fellow with the Fraser Institute and an Adjunct Scholar with the Cato Institute. He was President of the Federal Reserve Bank of Cleveland, a member of President Reagan’s Council of Economic Advisors, Dean and Professor of Economics at the University of New Mexico, and Chief Economist for two commercial banks. He has also served as Sr. Vice President and Director of Research at the Federal Reserve Bank of St. Louis and as a consultant to the Deutsche Bundesbank in Frankfurt, W. Germany.

Jordan earned his Ph.D. in Economics at the University of California, Los Angeles and his B.A. in Economics at California State University, Northridge. He holds honorary doctorates from Denison University, Capital University and Universidad Francisco Marroquin.