The Dubious Relationship Between Monetary Base & Inflation

Posted on April 16, 2012 by Matt Busigin

I think some people need to see this graph:

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In fact, you can search for the cross correlation between the 10-year %-change in CPI vs monetary base across lead/lag scenarios:

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This chart demonstrates that, at peak explanatory power, monetary base offers with a 42-months lead explains less than half of CPI. This means that, even with the strongest correlation found in this lead/lag search, 55.7% of inflation is explained by non-monetary base factors.  And that correlation is sinking every day.

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6 Responses to The Dubious Relationship Between Monetary Base & Inflation

  1. historysquared says:
    May 3, 2012 at 12:55 am

    Two studies, across many countries other than the US, show a long and variable lead time between expansions in the monetary base and inflation. The Fed uses a short-term outlook in their models, failing to account for the long and variable lead times between monetary manipulation and inflation, Fed historian and Carnegie Melon Professor Alan Meltzer notes. This myopic focus was on display in the 1970s. The US abandoned the gold standard in 1971: inflation hit Japan in 1972-73, then flowed back to the US, gathering steam throughout the stagflationary 1970’s, but failing to reach its zenith of an official 13% until December 1979 — 7 years later.”Bank of England Chairman Mervyn King studied the relationship between the growth in the monetary base and inflation for 116 countries from 1968-98. The 2-5 year correlation was not impressive; however, over periods like 5-10 years, “the correlations become almost perfect,” notes FT. “Over these longer horizons, the growth of the monetary base seems to be directly associated with the growth of both broad money and inflation. This association has been replicated in many other pieces of research, including this piece published by the Minneapolis Fed in 1995.”This association has been replicated in many other pieces of research, including this piece published by the Minneapolis Fed in 1995.”We’re only 3.5 years in, so a 1.5 to 6.5 year forward window would be expected according to the above studies.For example, the “Nixon Shock,” devalued the dollar versus gold 1971, but inflation did not hit 14% until 1980, after it went to Japan first (much like its gone overseas first). Additionally, following WWII, the monetary base no longer correlates with credit growth. This is due to securitization, which is defacto expansions in the supply of money in the system. You deserve credit for conducting the study – maybe try some different techniques, while adding data from other countries (such as Mervyn King’s or the Minneapolis Fed’s source)http://historysquared.com/2012/01/18/long-and-variable-lags-between-money-sup…

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  2. skeptik says:
    May 16, 2012 at 6:22 am

    What’s your source particularly for the first chart? What is the inflation metric?

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  3. Zippertheory says:
    May 16, 2012 at 6:35 am

    Skeptik, The source is from FRED http://research.stlouisfed.org/fred2/ and the inflation metric is CPI

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  4. skeptik says:
    May 22, 2012 at 5:28 am

    Thanks for your response. Have you considered the change in definition of the constituents of CPI over the years? I have heard of some “Boskin Commission” event that redefined the CPI in the ’80′s. This may account for drop in CPI relative to MB from 1980 on? Also, can I please get your comments re the relationship of gold price in USD vs major global currency printing? The gold bugs are showing a very convincing correlation between the combined printing of USD+Euro+Yen+Yuan relative to gold price rise on a percent basis.

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  5. hamptonus says:
    June 2, 2012 at 4:20 pm

    There’s a number of problems with trying to do simple ρ analysis of M2 and CPI. The most important is something called human agency. Humans understand that M2 increases the risk of inflation, so policy makers typically act to prevent any catastrophic outcome (Volcker, Greenspan, Triche).If you plotted ρ between total qty of landmines versus fatalities from landmines you’d have a similar problem.But if you’re point is strictly that there is no 1 to 1 immutable relationship between M2 and CPI, I absolutely agree, point well taken, but only a fool would disagree with that statement.

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  6. Matt Busigin says:
    June 2, 2012 at 4:34 pm

    M2 is not monetary base. M2 is manifested money supply growth. The false argument is that monetary base leads to M2 money supply growth. This is incorrect. It is likely a requirement, but beyond that, doesn’t actually promote it.

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