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U.S. hyperinflation? The markets know better

The supply of U.S. base money (currency and bank reserves at the Federal Reserve) has grown at an astounding rate since the financial crisis, with the percentage increase in 2009 alone equalling that of the 1990s. Despite this month's muted inflation data, commentators have argued that this is a sign that a U.S. hyperinflation is imminent. The position is understandable, as the connection between inflation and the M2 money supply (a broad definition of money which includes money in chequing and savings accounts and money market funds) is well known. However, unlike M2, the relationship between the growth of base money and inflation is weak, and in many cases negative.

An examination of the year-over-year growth of base money illustrates the low correlation with inflation, as shown in the attached graph. The average growth rate in base money in the high-inflation years of 1971-1980 was identical to that of the lower-inflation years of 1981-1990. Between 2005 and 2007, base money grew at the slowest rate since 1960-1962, though the period before the recession is not thought of as a period of tight money. Most telling is that outside of the last recession and the Second World War, the fastest period of growth for base money was during the Great Depression, a time of falling prices. This is not to suggest there is necessarily an inverse relationship between base money growth and inflation (for example, in the 1950s both base money growth and inflation were low), but rather that base money is a poor indicator of inflationary pressures.

The base money supply is typically increased to meet the demand for either bank reserves or physical currency. In the days before debit and credit cards were ubiquitous, the Fed would significantly increase the amount of currency in circulation before Christmas, when consumers wished to hold more physical currency to buy presents. The supply of physical currency and bank reserves were increased before 2000, as banks and individuals wanted to hold larger cash balances as a Y2K precautionary measure. We did not see a burst of Y2K-related inflation, because the Federal Reserve simply reduced the base money supply when it was no longer needed.

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The largest increases in the base money supply come during financial crises, as banks and other financial institutions wish to increase their reserves to prevent insolvency. Left unchecked, banks will eventually reduce their reserves and introduce this money to the broader economy, increasing the M2 money supply through the money multiplier process. The Federal Reserve can counteract this by decreasing the supply of base money, as it did after Y2K, or through increasing the demand for bank reserves through higher rates of interest on those reserves. While these actions are not costless to the Fed, they will ensure that the M2 money supply grows at the rate required to keep inflation in check.

Unlike many commentators, markets understand this process, which is why market estimates of future inflation remain relatively low.

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About the Author

Mike Moffatt is an Assistant Professor in the Business, Economics and Public Policy (BEPP) group at the Richard Ivey School of Business – Western University. Mike also does private sector consulting for the chemical industry. More

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