Prices rise until the real value of wealth held in the form of money is brought back into balance with the demand, writes David Ranson.

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About the author: David Ranson is head of research at HCWE & Co. in Portland, OR.

Contrary to a popular misconception, inflation is not caused by an excess of “demand” over “supply.” It’s far more likely to be a monetary phenomenon. Inflation is simply the cheapening of money—a loss in purchasing power of the monetary unit. 

Take the dollar. One way to cheapen it, the one everyone talks about, is for the banking system to inject more money into circulation than the public wants to use. Prices rise until the real value of wealth held in the form of money is brought back into balance with the demand. 

While this can happen, it’s not the only way to cheapen the dollar. More relevant to the current situation, there’s another way that is psychological rather than physical. The cause of present inflation has little to do with the quantity of money, and more to do with declining confidence in the future of the dollar as a store of wealth—its dependability, credibility, or quality. This reflects doubts about the way in which politicians drew upon monetary and fiscal policy to “fight” a Covid depression that never occurred. Prices rise until the dollar’s diminished purchasing power falls into line with the loss of confidence in its future. Whatever change might occur in the money supply is beside the point. 

Either way, it takes time for the cost of living to respond. The prices of commodities move first. Prices for goods and services follow—some more slowly than others. The earliest warning comes from precious-metal and commodity prices. These are the markets that provide the most direct way to measure the dollar’s quality. But there’s a catch. Historical evidence shows that the price of gold in distant forward markets is the most reliable benchmark, and not necessarily the cash price.  

This view of cheap money is a better fit for the current situation. Since Covid, public confidence in the monetary system has declined both domestically and internationally. Money in circulation is not growing proportionately to the inflation we are experiencing, as the “quantity view” implies. The closely watched money-supply metric M2, for instance, has hardly increased this year at all. But I agree with those who argue that the source of this inflation surge was reckless fiscal and monetary actions during the pandemic. They resulted from politics: the “for god’s sake do something” syndrome.

Which is the key to monetary disease—quantity or quality—makes a tremendous difference to policy making. Free-market advocates differ on these points and I’m well-aware that the quantity view dominates. But the rival view has its own approach to the challenge of reining in inflation. It is well-supported by history, which tells how different regimes have responded to inflation threats in the past. Those that relied on money-supply control or interest-rate hikes have had mixed results. Raising interest rates does not make a currency more sound! Rather the opposite: Unpredictable policies increase monetary uncertainty.

The quality view is always focused on making the dollar as sound as possible, and implies linking it to a constant standard. And that standard will have to be natural. If we have learned anything, it is that man-made standards don’t provide stability. They are politicized. The quality view implies currency-market intervention that links the dollar to a naturally stable asset such as gold. That’s something a currency board can do. It’s a way to restrain inflation without restraining growth. Indeed, it could be more than that. Were inflation to be curbed, growth would likely re-accelerate. 

The central-bank doctrine that currency-market intervention doesn’t work is losing favor. Dramatic successes have occurred where a monetary authority supported its currency using foreign exchange or gold reserves to buy it back from the markets. A recent example comes from a place where it might be least expected: Russia. But it makes sense. A huge fall in the ruble accompanied the early stages of the Ukraine invasion and the Western sanctions that followed. Forecasts of economic collapse drove the regime to desperate measures. Russia took a 180-degree turn and effectively linked the ruble to gold. It’s unclear how the Russians pulled this off, and no such policy has been confirmed by their central bank, but it worked. The ruble bounced back above pre-invasion levels and its new gold value in world markets has been quite stable. Inflation dried up, and a major downturn in the Russian economy has so far been averted.  

The Fed’s policy, in contrast, has been to hike interest rates and cut back the number of dollars in circulation. That’s the gospel according to the quantity view, and it’s not a policy to restore confidence in the soundness of money. It involves (at the least) putting the brakes on private enterprise and increasing the instability that financial markets abhor. 

In the end, a constant monetary standard is surely what the phrase “sound money” means. As economist Judy Shelton has pointed out, “money should provide a dependable store of value.” “Floating” has been all the rage since the Bretton Woods system anchoring the dollar to gold was dissolved. But it has led to where we are. Sound money doesn’t float. It stays put.

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