Why Are Prices Rising?

“What we are seeing is the old ploy by the robber who starts shouting 'Stop, thief!' And runs down the street pointing ahead at others.”

The late economist, Murray Rothbard

“Inflation is always and everywhere a monetary phenomenon.”

The late economist, Milton Friedman

M1 Money supply for the past 20 years.
M1 Money supply for the past 20 years.

The Federal Reserve often openly frets about inflation, and threatens to take any inflation that exceeds the 2% target very seriously. Yet, they never seem to talk about their own role in causing inflation. Everything from supply constraints to Covid related whiplash is to blame, just don’t look at the fox in charge of the henhouse. 

No doubt, supply constraints are a serious issue around the globe right now, but they didn’t just happen by chance. They were the inevitable result of government decisions to shut down large sections of the economy in response to a pandemic, and to offset the resultant short-term economic pain by paying millions of people to stay home and not work. Now, these decisions may, or may not, have been the right decisions to make. That isn’t the point of this article. We are only looking at the consequences of said actions, not whether they were justified or not. 

Unfortunately, the economy is not like a machine that can simply be turned off and then turned back on again. Intricate supply chains and relationships that have been developed for years were severed. Unfortunately, some of them will take years to restore. This is a practical matter that did occur and can’t be ignored, but we are looking for a root cause of inflation, not supply constraints. 

Although supply constraints are very real, they could never be responsible for a large and broad based rise in prices at a time when the overall economy is growing. The math just doesn’t add up. Think of it this way, if the economy is growing, the total supply of goods and services are increasing, and higher prices due to a supply constraint in one part of the economy should be more than offset by falling prices due to increased supply in other parts of the economy. 

In short, if the supply of money remained constant, but the economy increased the supply of goods and services, then the price of goods and services should fall relative to the amount of money available. The general purchasing power of the currency should be rising, not falling. Whether we experience supply constraints or not, during a period of strong economic growth, the only way money can lose significant purchasing power is if there is first a substantial increase in its supply. 

There are two major ways that the supply of money can increase. Either it can be loaned into existence by commercial banks, or the Fed can create new dollars via its QE programs. Prior to the the great financial crisis, almost all of the US economy’s money was loaned into existence by the commercial banks. 

In 2008 however, that all changed. That’s when the Fed became directly involved in the creation of the new dollars via its quantitative easing programs. Since then, they have gotten pretty good at it. Since the beginning of March of last year, the total money supply increased by $5.3 trillion. Of that amount, $4.2 trillion was created by the Fed via the monetization of debt securities. Absent this money creation, it wouldn’t be possible for prices to rise like they have been. 

First the Fed prints, THEN prices rise.

So, although there is a kernel of truth to the official reasons given as to why individual prices are rising, in aggregate, it is only possible because of the rapid and sustained increase in the supply of money by the Fed. Increasing the supply of money causes increasing prices. The Fed would love to make it much more complicated than that, but it doesn't have to be. 

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