During the 1990s and 2000s, the quantity theory of money (QTM) fell out of favor among both policymakers and academics. The central bank response to the Global Financial Crisis (GFC)—which featured the large-scale asset purchases called “quantitative easing” (QE)—breathed life back into the quantity theory and its adherents. The Fed’s policy led to a nearly fourfold increase in the U.S. monetary base from August 2008 to August 2014!
But as things turned out, this monetary expansion turned out to be much ado about nothing. During the 13-year period ending in December 2020 in which U.S. M1 grew by an annual average rate of 12.7%, inflation averaged just 1.6%. The prediction of QTM that inflation would mirror money growth over the long run has been wildly off the mark. Although things could change quickly, even today’s capital market expectations for “long-run” U.S. inflation appear to be running within a 2%-3% band.
Former International Monetary Fund director of central banking Peter Stella, writing in the Journal of Applied Corporate Finance, explained why the QTM is no longer a useful “cheat code” for interpreting modern monetary reality. As the most promising replacement, he offered the outline of a “fiscal theory of the price level” that has had more success in explaining global inflation during the past several decades. As its name suggests, the fiscal theory emphasizes that the underlying driver of inflation is government deficit spending while minimizing the importance of the instruments—whether money or debt—that governments use to finance their deficits.
Because the policy response to the GFC primarily involved the exchange of bond financing for monetary financing without a significant increase in total sovereign debt, it did not prove inflationary. The response to the global pandemic, by contrast, has involved a significant deterioration in sovereign fiscal finances. But whether this turns out to be inflationary is likely to depend not on how the current deficits are financed in the moment, but on the commitment of sovereigns to shoring up their fiscal positions without resorting to a reduction in the real value of their own debt.
