This is, of course, a domestic effect. But when currency exchange rates. freely float against each other and there are no barriers to international trade, generally rising prices tend to cause the exchange rate of the currency to fall versus the currencies of the country’s trading partners. Conversely, falling prices (deflation) tend to cause currency exchange rates to strengthen
Importantly, it is not just current inflation that economists believe affects currency exchange rates, but expectations of future inflation. When prices are rising, people can start to expect even larger price rises in future, and demand higher wages to compensate them for rising living costs, forcing businesses to raise prices and thus feeding the inflationary spiral. If the central bank responds to this by printing more money, inflation may rise even faster, leading people to lose confidence in the central bank and reject the currency completely, causing “hyperinflation”. 3
Conversely, when prices are falling people may defer purchases in expectation of further decreases, making it difficult for businesses to sell goods and services. A deflationary spiral can cause widespread debt defaults and bankruptcies, very high unemployment and a severe economic slump.4High inflation and severe deflation are both rightly feared, and central banks devote a great deal of attention to keeping inflation low and stable.
Economists Say Controlling the Supply of Money is Key to Managing Inflation and Exchange Rates
The Quantity Theory of Money says that managing the amount of money in circulation can control both the currency exchange rate and domestic inflation.5 When domestic prices are rising, reducing the amount of money in circulation will increase the value of money relative to goods and services, dampening down price increases. Conversely, increasing the amount of money in circulation will prevent the kind of deflationary spiral last seen in the Great Depression, when dollars became extremely expensive relative to goods and services.6 Central banks therefore aim to maintain a low, stable inflation rate by controlling the amount of money in circulation.
In the aftermath of the financial crisis of 2008, central banks – fearing a repeat of the disastrous deflation that followed the Wall Street Crash of 1929 – flooded their economies with new money through a variety of money-creation programs that are collectively known as “quantitative easing” (QE). Many people expected this vast increase in the money supply to create runaway inflation.7 But now, nearly nine years on from the 2008 crisis, all that QE seems to have had little inflationary effect. To be sure, we do not know whether deflation would have been worse without it. But the lack of inflation has left economists scratching their heads. Inflation, it seems, does not work quite as they thought it did.8
It All Depends on What You Mean by Money and Foreign Exchange Rates
In a new paper, five economists turn the thinking about the causes of inflation on its head. They show that expectations of inflation have little relationship to the reality. 9 And, echoing International Monetary Fund (IMF) research findings in 2013, 10 they also show that high inflation does not necessarily mean high wage growth.
So what does drive inflation?
For consumer price index (CPI) inflation, which is the “headline” inflation rate that central banks target, the principal drivers are the rate of change of what is known as “broad money.” This is not money created by central banks. It is money created by commercial banks in the course of making loans or buying securities. 11 Thus, the rate of change of “broad money” and the rate of change of debt are related – and neither is directly related to central bank money creation.12 We can deduce, therefore, that one reason why the money created by QE did not cause runaway inflation might be because in the aftermath of the financial crisis, damaged banks were not lending, so broad money (debt) did not grow enough to cause CPI inflation. 13
Global Markets Have Become the Important Drivers of Inflation and Exchange Rates
There is, however, another important driver of CPI inflation, and that is global prices for oil and commodities.14 Recent evidence from the U.K. shows that producer price inflation (the prices that businesses pay for physical inputs) is principally driven by movements in the oil price, and to a lesser extent by movements in food and commodity prices.15 These are determined by global market conditions. The U.K. evidence shows that CPI inflation varies much less than producer price inflation, which raises the question – if producers don’t raise consumer prices much when faced with large increases in input prices, who bears the cost? In the U.K., the cost appears to be born by workers in the form of stagnant or declining real wages.16
In addition to CPI inflation, central banks also like to manage “core” inflation, which excludes volatile items such as oil and commodity prices. Here, the driver is different. The economists identify movements in the currency exchange rate as the principal driver of core inflation.17
Their findings reverse the previously thought direction of causality between inflation and exchange rates. Instead of rising prices causing the exchange rate to fall, a falling exchange rate causes import prices to rise, fueling domestic inflation via business supply chains. This raises questions about the extent to which modern financial markets influence global economic conditions. Perhaps it is no longer trade in goods and services that governs exchange rates, but trade in the currencies themselves.
The Takeaway:
Although Friedman’s famous maxim still has some validity, today’s “money” is now determined more by commercial banks than central banks, so the behavior of commercial banks has become a key driver of inflation (or deflation). And due to the development of international supply chains, global market prices now significantly influence both currency exchange rates and inflation. Inflation is no longer a simple question of supply and demand in the domestic economy.
Sources
- “Is inflation (or deflation ‘always and everywhere’ a monetary phenomenon?,” Masaaki Shirakawa; http://www.bis.org/publ/bppdf/bispap77e.pdf
- Ibid.
- “The Monetary Dynamics of Hyperinflations,” Cagan;http://people.bu.edu/rking/SZGcourse/Cagan.pdf
- “The Debt Deflationary Theory of Great Depressions,” Irving Fisher; https://fraser.stlouisfed.org/files/docs/meltzer/fisdeb33.pdf
- “The Quantity Theory of Money,” Investopedia; http://www.investopedia.com/terms/q/quantity_theory_of_money.asp
- “The Debt Deflationary Theory of Great Depressions,” Irving Fisher; https://fraser.stlouisfed.org/files/docs/meltzer/fisdeb33.pdf
- “Will All The Money Printing Lead To Hyperinflation?,” CNBC; http://www.cnbc.com/id/47960752
- “The Dog That Didn’t Bark: Has Inflation Been Muzzled or Was It Just Sleeping?,” International Monetary Fund;https://www.imf.org/external/pubs/ft/weo/2013/01/pdf/c3.pdf
- Deflating inflation expectations: The Implications of Inflation’s Simple Dynamics, Cecchetti, Feroli,Hooper, Kashyap & Schoenholz; https://research.chicagobooth.edu/~/media/806FC2DED9644B5DA99518D2B07CC637.pdf
- The Great Recession and the Inflation Puzzle, International Monetary Fund; https://www.imf.org/external/pubs/ft/wp/2013/wp13124.pdf
- Money creation in the modern economy,Bank of England; http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf
- “When Wonks Get Things Wrong,” Pieria; http://www.pieria.co.uk/articles/getting_things_wrong_federal_reserve_style
- Getting Credit Flowing: A Non-Monetarist Approach to Quantitative Easing, Adam Posen; https://pdfs.semanticscholar.org/33ab/078dff3c1aeec2342da62a551663d4e82d06.pdf
- “Everything the Market Thinks About Inflation Might Be Wrong,” WSJ; https://www.wsj.com/articles/everything-the-market-thinks-about-inflation-might-be-wrong-1488796206
- “UK inflation and the oil price,” Coppola Comment http://www.coppolacomment.com/2017/02/uk-inflation-and-oil-price.html
- Ibid.;
- Deflating inflation expectations: The Implications of Inflation’s Simple Dynamics, Cecchetti, Feroli,Hooper, Kashyap & Schoenholz; https://research.chicagobooth.edu/~/media/806FC2DED9644B5DA99518D2B07CC637.pdf