Back in April 2021, I wrote a blog post with the title “Heading for double-digit US inflation” in which I warned that we were likely to see a sharp increase in US inflation.

We didn’t quite get to 10% but it was close and US inflation certainly turned into the main US policy issue in 2021-22.

My forecast was based on two simple facts.

First, of all the fact that we in 2020-21 saw the largest expansion in the US money supply (I used M2 to illustrate that) ever in peacetime.

This is essentially a monetarist story – if you expand the money supply faster than the growth of money demand then nominal income growth will accelerate and sooner or later you will as Milton Friedman taught us have inflation.

The second point was that in early 2021 the Federal Reserve was eager to tell us that the increase in inflation was ‘transitory’. Or said in another way the Fed essentially refused to take responsibility for controlling over the development in nominal income and hence in inflation.

This is point is market monetarist in the spirit of Robert Hetzel – if the Fed refuses to do its job then it will cause an expectational shift that will accelerate the increase in inflation.

So to me, it was fairly straightforward to forecast higher inflation in the US at that time.

I fully admit that other factors played a role as well such as the much talked about “supply chain” problems as a result of Chinese Covid policies and higher energy prices, but I generally think the importance of these issues have been significantly overestimated.

The core reason US inflation rose sharply in 2021 was excessively easy monetary policy and the Fed’s refusal to take responsibility for price stability.

Furthermore, it should be noted that US inflation, in fact, rose well ahead of Putin’s invasion of Ukraine and inflation actually started to decline in 2022 – after the Fed demonstrated that it would again start to take responsibility for ensuring price stability.

In fact, US inflation was lower by the end of 2022 than at the beginning, which fits badly into a story that this was caused by Putin’s war.

However, the moderation in US inflation during 2022 fits well into the monetarist story I told in 2021. I will return to that below.

The graph below shows the simulation of a so-called P-star model – which is based on the monetarist quantity theory of money – I used to forecast inflation back in April 2021 and the actual development in US inflation since then.

My simulation from 2021 certainly didn’t get it perfectly right, but it is notable that we did indeed see a sharp spike in US inflation as forecasted, but it is equally notable that in the simulation from April 2021, we also saw that inflation wouldn’t just continue to accelerate.

In fact, the simulation indicated inflation would moderate – from a very high level – during 2022. This is in fact also what we have seen.

So our model both got the spike in inflation right in 2021 and the moderation in inflation in 2022 right. The difference, however, was that inflation didn’t quite increase as much (and as fast) as the initial simulation had indicated it would.

To understand that we need to go back to our original model – The P-star model – and what assumptions regarding monetary policy (and the monetary transmission mechanism) I made then.

The P-star model

In my blog post in April 2021, I based my forecast or simulation of future inflation on the so-called P-star model.

The P-star model is based on the equation of exchange:

(1) M•V=P•Y

Where M is the money supply (I used M2 for the US), V is the velocity of money, P is the price level and Y is the real GDP/Production.

If we assume that V over time follows a trend that is determined by structural factors such as financial regulation and demographic and similarly we assume that over time there is a potential level of Y that is determined by structural factors such as technology, taxes, the size of government, demographics, etc. then we can re-write (1):

(2) P* =M•V*/Y*

Where P* (or P-star) is the level of prices in the economy we should expect in the long run given the actual level of the money supply and the structural levels of V (V*) and Y (Y*).

The graph below shows my calculation of P* back in April 2021.

We see at that time due to the sharp increase in the money supply in 2020-21 P-star was significantly above the actual price level and that is basically why I made the call that inflation would increase sharply.

And as discussed above inflation did indeed rise very sharply as forecasted. However, we didn’t quite get to double-digit inflation as the simulation had indicated would have happened.

The Fed turned more hawkish than assumed

When I made the simulations back in April 2021 the Fed was still talking about inflation as something the Fed could not control and as ‘transitory’.

Hence, in March 2021 Fed chairman Jerome Powell said “However, these one-time increases in prices are likely to have only transient effects on inflation”.

Said in another way the Fed had no plans to tighten monetary policy.

So when I made the simulation in 2021 I had to assume that at least for some time the Fed would not tighten monetary policy but also that the Fed would not forever ignore the likely increase in inflation that I was forecasting.

So in my simulation in April 2021 I assumed that starting from May 2021 US money supply would gradually start to slow and from early 2022 it would follow the trend in money supply growth, which ensured around 2% inflation from 2010-19.

However, if we compare this with the actual development in money supply growth we can see that the Fed has turned decisively more hawkish than I had assumed it would.

The graph below shows the level of the US money supply (M2) that I assumed it would follow and how it actually developed.

We see that the development actually followed my assumption fairly closely through most of 2021 but from around November 2021 the growth of the money supply slowed dramatically and during 2022 the US money supply actually declined.

Interestingly enough the rather abrupt slowdown in money supply coincided with the reappoint of Fed chairman Jerome Powell and also with a maked shift in the communication from the Fed. Hence in late November 2021 Powell said “We tend to use [the word transitory] to mean that it won’t leave a permanent mark in the form of higher inflation.”…”I think it’s probably a good time to retire that word and try to explain more clearly what we mean.”

The gap between the ‘forecasted’ and the actual M2 level, however, particularly started opening up from April-May 2022, which marks an ‘acceleration’ of monetary tightening.

Consequently, we should expect inflation to continue to come down faster than forecasted in April 2021.

Re-doing the April 2021 simulation

When I did the simulation in April I used the P-star model to calculate the gap between the actual US price level and P-star – the P-gap.  

To do that I also needed to make assumptions about how fast the P-gap would close – or rather how sticky the inflation rate would be.

Given inflation didn’t increase as much as the simulation had indicated then is an indication that inflation was more sticky than I had assumed.

This is important when we need to forecast inflation going forward. We need to take into account this stickiness in inflation.

In the graph below I have essentially redone the simulation from April 2021, but done it will the actual development in the money supply and adjusted what we could call the ‘stickiness parameter’. We see that this simulation fits the actual inflation development remarkably well.  

I think it is important to note that price stickiness not only reflects that certain prices are fixed by contracts but also to a very large extent is determined by expectations. Hence, if economic agents expect the Fed always to conduct monetary policy in such a way that inflation will alway will be close to 2 percent then even a significant increase in the money supply will not cause a major increase in inflation.

But overall to the extent the original simulation from April 2022 was wrong, it was not primarily due to a wrong assumptions about money supply growth (in it was more or less correct for at least the first 8-12 months). The primary mistake in the simulation hence was the assumption about the degree of price stickiness.

So we certainly should not abandon the P-star model. Rather the model correctly forecasted the sharp rise in inflation and also that inflation would eventually come down again as the slowdown in money supply growth sat in. It is therefore also worthwhile updating the forecast from the model.

This is what I have done below.

Inflation seems set to drop significantly

In many ways, the forecast/simulation from April 2021 was a ‘control experiment’ as the US economy had been in a lockdown and the money so to speak had been printed. We can compare this to a situation where we drink a bottle of whiskey and now forecast that we will get a hangover. It is nearly given by nature that this will happen.

When I forecasted inflation to rise strongly in April 2022 the money had already been printed. There was at that time little to do about it – the hangover would arrive soon in the form of a sharp increase in inflation. The only question was how fast it would take the Fed to ‘stop drinking’ and slow money supply growth.  

The situation now is very different in the sense that it is much less clear what the Fed will do from here. The clear geopolitical risks, the upcoming US presidential elections in 2024 and a potential US recession all could trigger both changes in inflation expectations and also changes in the Fed’s policy reaction function.

So it is certainly not as straightforward to forecast inflation now as it was in April 2021. However, that is no reason for not trying.

But instead of making one forecast, I have instead made two different scenarios for US inflation based on two different assumptions for US money supply growth going forward.

The first scenario is what we could call the ‘hawkish’ scenario. In this scenario, I have essentially assumed that all of the excessive money supply growth during 2020-22 will be undone so the level of the US money supply will return to the ‘old’ 2010-19 trend in the coming year. This basically implies that the slowdown (relative to the pre-2020 trend) in M2 growth continues basically until we are back at the old trend in level terms.

In the second scenario – the ‘dovish’ scenario – I have assumed that from now on – Q1 2023 – US money supply growth will return immediately to the same growth rate as we saw pre-2020 but starting from higher a high level. This is what we normally would term letting bygones-be-bygones.

In both scenarios, the M2 will eventually grow at the same pace but the level of M2 will be different.

In the graph below I have simulated two different scenarios for US inflation based on the two different assumptions for M2 growth going forward and I have used a ‘stickiness parameter’ that ensure the best fit for inflation in the 2021-22 period.

A number of factors should be noted regarding these simulations. First of all, it should be noted that even though US money supply growth has slowed rather dramatically for more than a year there still is a considerable ‘monetary overhang’ – what I above called the P-gap is still positive (around 6-7% versus around 15% at the peak in early 2021). This means that even though money supply growth remains subdued there still are considerable ‘pent-up’ inflationary pressures.

On the hand as Milton Friedman often noted – monetary policy works with long and variable lags. In the simulations above I have assumed (based on the historical relationship) that there is a six-month lag between an increase in the P-gap and higher inflation. This also means that it will take time to bring inflation down, but also once money supply growth has slowed the impact will continue to feed through to inflation over a longer period.

These factors are clearly visible in both scenarios. First of all, we see that in the first half of 2023, inflation drops basically equally fast in both scenarios and the reason for that is that since we have assumed a six-month lag between changes in money supply growth (and therefore in the P-gap) it will take six months before any change in monetary policy is visible in inflation.

Therefore, in the model set-up any slowdown in inflation in the coming six months will be due to the slowdown in money supply growth we saw during 2022.

What is notable is that in the ‘hawkish’ scenario US inflation will continue to decline until the Autumn of 2025 and drop well below Fed’s 2% inflation target.

On the other hand in the ‘dovish’ scenario inflation will come down toward 2% gradually over the next 3-5 years.

The most likely scenario probably is a combination of the two scenarios where the Fed is likely to follow a stop-go or go-stop policy. Hence, with inflation likely to drop significantly in the next 3-4 months the Fed is also likely in that period to end it hiking cycle and therefore also to gradually start to re-accelerating money supply growth.

But the Fed also is likely to struggle with the famous long and variable lags – either by waiting too long to end monetary tightening or by initaiting easing monetary policy too early.

I think that there should be relatively little doubt that inflation will come down toward 4-5% over the next 6 months in the US. However, the tricky part will be for the Fed to get inflation back towards 2% and the policy discussion is likely to intensify in the second half of the year.

Even though the Fed is far from being able to declare victory on inflation we are nonetheless likely to see inflation worries subside considerably (unless a new major supply shock hits) in the coming 6 months.

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Contact:

Lars Christensen, lacsen@gmail.com