The inflation conundrum

In many previous posts, I have argued the current sharp rise in inflation rates in all the major economies does not derive from so-called ‘excessive demand’; or from excessive money supply growth; or wage demands forcing companies to raise prices.

It primarily relies on the failure of supply to match demand.  Supply was drastically squeezed during the COVID pandemic slump of 2020 and the productivity of labour contracted sharply.  Capitalist investment and the production revival during the economic recovery in 2021 were inadequate to meet to renewed spending by consumers and companies.  That failure was exacerbated by supply-chain blockages (loss of employees in key industries and the collapse of trade and transport connections).  And the Russia-Ukraine conflict then added to that in reducing energy and food supply and exports, causing rocketing food and energy prices.

What does this show about mainstream economic theories on inflation and policies to reduce inflation?  The answer is that they have been exposed as wrong or irrelevant in theory; and downright damaging in policy. In particular, central banks, separated from democratic control by their governments and mandated to meet some arbitrary inflation rate target using changes in basic interest rates and in the amount of monetary injections or withdrawals, are proving to be totally useless in bringing inflation under control.  Instead, central bank monetary tightening is just driving economies into recession faster and deeper.

Let’s remind ourselves of the two main theories of inflation offered to us: the monetarist and the Keynesian wage-push theories.

On the first, the evidence is clear.  The relation between money supply growth and CPI inflation is not significant. Indeed, from the mid-1990s, money supply growth has accelerated and yet CPI inflation has slowed – something mainstream economics and central bankers have not been able to explain or deal with.  I find that the correlation between money supply growth and CPI inflation from 1960 to 1992 was just 0.11 and from 1993 there was no positive correlation whatsoever!

In an interesting paper by Louis-Philippe Rochon, he provides many sources that show the inadequacies of both the monetarist and classical Keynesian theories of inflation. Rochon quotes Cynamon, Fazzari and Setterfield: “The transmission mechanism from monetary policy to aggregate spending in new consensus models relies on the interest sensitivity of consumption. It is difficult, however, to find empirical evidence that households do indeed raise or lower consumption by a significant amount when interest rates change.”  And nor do interest rates change investment much.

Even arch Keynesian Paul Krugman acknowledged this: “It’s a dirty little secret of monetary analysis that … any direct effect on business investment is so small that it’s hard even to see it in the data.” (November 15, 2018, NYT blog).  Of course, he went on to argue that “what drives such investment is, instead, perceptions about market demand.”  I shall return to that point later; but clearly in the post-pandemic period, demand does not seem to have driven investment and production up, which is why we have inflation rising from supply blockages. Even the Federal Reserve economists have admitted that “a large body of empirical research offers mixed evidence, at best, for substantial interest-rate effects on investment. [Our research] find that most firms claim their investment plans to be quite insensitive to decreases in interest rates, and only somewhat more responsive to interest rate increases.” (Sharpe and Suarez).

As for the wage push theory of the Keynesians, it also falls theoretically and empirically.  It only compares wages to prices, which is just part of total value creation.  What about profits?  The size or share of profits is totally ignored.  This is ideological bias and theoretically false. It is well documented that wages as a share of GDP have fallen in the US over the last 50 years as a trend – or at the very least has not risen as a share of new value. 

Also, there appears to be no inverse correlation between changes in wages, prices and unemployment.  The classic Phillips curve that claimed such a relation has shown to be false.  Indeed, this was found out in the late 1970s when unemployment and prices rose together.  And the latest empirical estimates on the Phillips curve show it to be broadly flat – in other words there is no correlation between wages, prices and unemployment.

Mainstream economists have been forced to recognise this. A labour specialist at the US Bureau of Labor Statistics, Politano concluded that “Over the last 20 years, the Phillips curve relationship has nearly completely broken down in the United States”.  And Mary C. Daly, President of the Federal Reserve Board of San Francisco, also concluded that “As for the Phillips curve … most arguments today center around whether it’s dead or just gravely ill. Either way, the relationship between unemployment and inflation has become very difficult to spot.”  

Naturally Austrian school BIS economist Borio agreed: “the response of inflation to a measure of labour market slack has tended to decline and become statistically indistinguishable from zero. In other words, inflation no longer appears to be sufficiently responsive to tightness in labour markets” and again more recently he concluded that “inflation has proved unexpectedly unresponsive to economic slack – the Phillips curve is very flat.”  The current Fed Chairman, Jerome Powell, has acknowledged the problem: “We are also aware that, over time, inflation has become much less responsive to changes in resource utilization” (Powell, 2018).

This uncomfortable conclusion was also reached by two prominent mainstream economists in two papers, published in the Review of Keynesian Economics.  Robert Solow remarked that “The slope of the Phillips curve itself has been getting flatter, ever since the 1980s, and is now quite small. … there is no well-defined natural rate of unemployment, either statistically or conceptually.” And Robert Gordon echoed: “The slope of the short-run inflation–unemployment relationship has flattened.”  

So why do economists and central bankers continue to peddle a theory that has no empirical support?  Gavin Davies, a Keynesian and former chief economist at Goldman Sachs, explained: “without the Phillips Curve, the whole complicated paraphernalia that underpins central bank policy suddenly looks very shaky. For this reason, the Phillips Curve will not be abandoned lightly by policy makers”.

When theories are incorrect, the policies that flow from them won’t work.  Macro management of the capitalist economy, either based on monetarist theory or Keynesian fiscal fine-tuning, has failed to avoid or ameliorate booms and slumps in capitalist production. As Richon says: “Belief in fine-tuning and the existence of a natural rate of interest often leads central banks to increase interest rates repeatedly until they engineer a recession, which then slows economic activity, raises unemployment, and inflation finally collapses. This perfectly illustrates the asymmetric power of central banks and monetary policy: lowering rates may have no impact on launching investment (you can bring a horse to water but you can’t force it to drink), but can certainly do considerable damage, if central banks stubbornly raise interest rates high enough: this is akin to using a sledgehammer to kill a fly: you will kill the fly, but also the table on which it was resting. This is precisely what Keynes had in mind when he stated that fine-tuning “belongs to the species of remedy which cures the disease by killing the patient” (Keynes 1936, p. 323). And yet, macro management of fiscal and monetary policy is the reason for the existence of inflation targets for central banks and deficit and debt targets for governments.

So what does cause inflation rates to accelerate or disinflate?  The mainstream does not know.  The post-Keynesians turn to profit mark-ups. “From the viewpoint of the post-Keynesian theory of distribution, the functional redistributional effect of changes in interest rates centres directly on the responsiveness of the mark-up to interest rates … [which] will presumably depend both on the magnitude and expected permanence of interest rate changes.” Richon. So it’s the ability of (monopoly) corporations to mark up prices and engage in price gouging that causes inflation.

It’s true that profit rises have made the largest contribution to price rises in the post-pandemic period.

But monopoly or oligopoly cartels have existed since the development of mature capitalism and there has been an increasing degree of concentration of capital, as Marx predicted.  But that has not always been followed by accelerating inflation.  Indeed, from the early 1990s up to the Great Recession and beyond, inflation rates in the major economies fell and central banks were puzzled at their inability to get inflation up to their target rates. 

The mark-up theory of inflation is not born out by the evidence.  As James Crotty put it: “the constant-mark-up Kalecki model of profit determination” used by post-Keynesian hero Minsky ”is evidently unsatisfactory.”  According to Crotty: “The bulk of evidence demonstrates that there is significant cyclical variation in the mark-up and the profit share”.  In other words, the ability of corporations to raise prices and gain more profit share varies according to the rate of expansion in the economy.  Before the pandemic slump, corporate profits made up only 11% of changes in unit prices (see graph above).  That means we need to look for the causes of inflation in the trajectory of the capitalist economy, not in monopoly mark-ups per se.

So if accelerating inflation is not caused by excessive money supply (monetarist) or by wage cost-push (Keynesian); or even by monopoly mark-ups (post-Keynesian), what does cause it?  What is the Marxist theory of inflation? In earlier posts, Guglielmo Carchedi and I have attempted to develop a Marxist model.  In the upcoming Historical Materialism conference in London, I shall expound on this in a morning session on Saturday 12 November, with a proper paper to follow.

20 thoughts on “The inflation conundrum

  1. Reblogged this on DAMIJAN blog and commented:
    “Mary C. Daly, President of the Federal Reserve Board of San Francisco, also concluded that “As for the Phillips curve … most arguments today center around whether it’s dead or just gravely ill. Either way, the relationship between unemployment and inflation has become very difficult to spot.”

    So why do economists and central bankers continue to peddle a theory that has no empirical support? Gavin Davies, a Keynesian and former chief economist at Goldman Sachs, explained: “without the Phillips Curve, the whole complicated paraphernalia that underpins central bank policy suddenly looks very shaky. For this reason, the Phillips Curve will not be abandoned lightly by policy makers”.”

    1. It’s not just economists and bankers who peddle theories with no empirical support. I am being inundated with the new left cult of MMT and every time I ask for the empirical data that supports it I’m just met with amazement and told I haven’t read it properly. I think people tend to hold to beliefs that confirm their prejudices and can take a lot of shaking out of them. Its a process that TS Kuhn described in the structure of scientific revolutions where he says scientists (are economists scientists?) when faced with data that doesn’t fit will look for more data rather than accept that the data is right and the theory wrong. Only when it becomes absolutely obvious that the data can’t be made to fit will they reluctantly change the theory.

  2. Thanks Michael this is really useful. I am curious about that first chart. It would tend to suggest not only that there is no great correlation between money supply and inflation but unless I’m completely misreading it (highly possible as I’m not an economist) as the money supply increases, so too does inflation. If that’s true what would that mean for MMT’s solution of printing more money to buy us out of recession.

    1. Hi Dave,

      While the first chart shows M2 money supply, it is not very focused. I would suggest viewing the chart from FRED ( You can see the rate of change is constant, thus no inflation. But in February 2020, the M2 money supply grew exponentially, a strong indicator of inflation. Very interested in hearing your thoughts on this M2 money supply chart!

  3. So, if I understand this correctly, millions of working-class folks have been thrown out of work over the decades in our capitalist economy as the Federal Reserve uses a now discredited theory of raising interest rates to control inflation?

    Another reason to ditch capitalism; an economic system in which the top 1% get exorbatently rich off the backs of the working class.

  4. I’m not a post-Keynesian. However, most of the left right now blames profiteering as the cause of inflation. I assume it contributes something – oil prices and the production cut might be the biggest indicator of that This is no doubt a vast political move, but what is the percentage of contribution, do you think? Zero?

  5. I would have liked to attend your talk as they are always useful, but as I have cut my ties to Historical Materialism, please accept this comment as a contribution to your session.

    You are right to say that the Phillips curve has been filibustered. But the Phillips Curve was always going to be a minor side show in the discussion on prices and their movement, even used as a fig leaf. The real story begins a century earlier when bourgeois economics abandoned classical theory (Smith, Ricardo and Marx) for neo-classical theory, or what is the same thing, moved theory centered on production to being centered on exchange and therefore from prices being determined by the actual costs production (exchange value) to prices being determined by the act of exchange itself where use value has a presence. Once the capitalist class abandoned a cost-based approach to prices it opened the way for all the latter-day SUBJECTIVE theories on inflation including its most vulgar apostle – monetarism. From then on economists, including the Keynesian variety, lost the ability to explain inflation except in extreme cases.

    However, the cost based approached to pricing over time has always proven to be correct. What caused prices to fall prior to the pandemic, the so-called secular trend, was the international restructuring of the division of labour centering on China which had a dramatic effect on the cost structure of global production. All the central bankers and all the monetarists could huff and puff as much they wanted, but they could not blow down this emerging cost structure.

    The fact is that prices orbit in the gravity well created by value, orbits which are continuously disturbed by the restless movement of capital under the influence of the galactic phasing of the industrial (business) cycle. (Now, how’s that for a turn of phrase.) This is important for what is to come. The present restructuring of global supply chains, including the splitting of the global economy in two, will mean a significant rise in the actual global costs of production. (For example, reshoring chip production to the USA will cost 44% more according to Goldman.) Thus, a cost-based approach to pricing would suggest the secular downward trend in prices is over. Except that we will never know because we are entering the deepest slump since the Second World War. What will be known is that the profit margins of the global corporations which benefited so much from the Covid Funds will in the same proportion, but inversely, be crushed.

    Just a quick point. Trade credit is the biggest form of credit in the economy in terms of annualized originations and terminations. It is also that form of credit which is most sensitive to interest rate rises because it more than any other form of credit, is designed to sidestep money. Until I unearthed the turnover formula it was impossible to quantify trade credit, but it is now possible to estimate its size, and it is vast. The point I am making is that while the economy is insensitive to rate falls, it is much more sensitive to rate rises, whereas speculation is sensitive on BOTH sides. Also, the economists you quoted don’t seem to appreciate that demand can be indirectly influenced by interest rate falls such as lower mortgage rates which encourages refinancing which in turn releases money for spending. Currently refinancing mortgages are down over 80% YoY because of soaring mortgage rates which has helped decelerate personal consumption.

  6. Yours and Carchedi’s Marxist theory of inflation for a fiat currency model is essentially correct. There’s no need to delve too much into other bourgeois arguments and “theories” (which are not really theories in the rigorous, scientific meaning of the term, but mere conjectures at best).

    As for the “Rochon’s dilemma”, it can be elegantly explained by Marx’s Theory of Value: in order for amplified reproduction to happen, simple reproduction has to happen “first”, or, more precisely, amplified reproduction has simple reproduction in itself. Surplus value is simple value beyond a certain point, i.e. it is a purely subjective category, it only exists socially.

    So, if we take, e.g. a household, it will first have to reproduce itself as a household before thinking about increasing or decreasing consumption. This bare minimum (simple reproduction) includes not only the obvious, self-evident essential material conditions (food, energy, transport), but also class relations’ conditions (i.e. a middle class household will have to spend the costs of keeping itself in the middle class). Below that minimum limit, there can be no talk about monetary policy influencing spending – unless you’re talking about the literal erosion of the middle class, the working class, the lumpenproletariat etc. and, therefore, the very so-called “social fabric” of the given capitalist society being analyzed. This is indirectly glimpsed by bourgeois “theory” through the “elastic/inelastic demand” classification of commodities.

    The families (households) don’t think in monetary terms. They think in what they have to do to survive within the social class they already are, in concrete, simple reproductive terms (what we need to buy: food, housing, energy, healthcare plan, private schools tuition – the infamous “how to pay the bills”); they do not look at the Fed’s interest rates and conclude “well, now that interest is at 5% that means we suddenly demand 2.1% less”; that’s not how the real world works.

    As I see the situation in the USA right now, my opinion is this: an advanced stage of profit rate decline has finally caught up the American Empire (i.e. the Capitalist Empire), whose “social fabric” is starting to shrink and dissolve, due to the incapacity of revalorization of its very economic base (i.e. simple reproduction phase of amplified reproduction). Some islands of prosperity (e.g. the FAANGS), plus the capacity to recall capital from the provinces of the Empire (see, e.g. recession in Europe and the coming degradation of the SE Asian financial sector) has kept the US proper afloat so far (+2.6% this quarter, after two quarters of contraction), but it has already fallen behind its main enemy in this historical phase: socialist China.

    China, even though much less formidable than the Soviet Union, has now the advantage of facing a much (relatively speaking, era-adjusted) weaker Capitalist Empire (the UK, then the USA) than the Soviet Union, which had to face the USA at its apex. The situation for China now is akin to facing the Byzantine Empire rather than facing the classical Roman Empire at its apex (the “High Empire”): it is not the USSR, but it doesn’t have to be.

  7. I am quite sure that the easy monetary policy of central banks influence inflation. If trillions of dollars entered the economy in one way or another prices are going to reflect it. It doesn’t mean any kind of ‘monetarism’ (M. Friedman) as a theoretical frame. Other causes are contributing to inflation and the question: Why an easy monetary policy was implemented should be answered because the rate of return on capital has fallen.

  8. M. Roberts paraphrasing Crotty: “In other words, the ability of corporations to raise prices and gain more profit share varies according to the rate of expansion in the economy. ” The GDP fell by 9.4% between 2019 Q4 and 2020 Q2, it did not recover its previous height till 2021 Q2. Extraordinary inflation-rate increase began in the U.S. from January 2021 and plateaued around July 2022; it had risen 13.2% in 18 months, which annualizes at 8.8% over the 18 month period. The savings rate between 2020 Q2 and 2021 Q2 also increased during the locked-down period, it averaged 19.3% for 12 months (, Table 2.1). It had been around 9% pre-pandemic. It’s now at 3.4% in Sept. 2022. The vaccines arrived about January 2021 and the economy expanded rapidly. Corporate mark-ups also increased around this period of expansion, I am guessing, since it was 53.9% of the driver of inflation. My point, corporations increased their prices due to pent-up demand, post-pandemic, as the economy expanded. Inflation ensued. Crotty was right, “there is significant cyclical variation in the mark-up and the profit share”.

  9. “Indeed, from the mid-1990s, money supply growth has accelerated and yet CPI inflation has slowed – something mainstream economics and central bankers have not been able to explain or deal with.”

    This is easy to explain.

    Solving the enigma of the ‘velocity decline’

    The problems arising from the implicit assumption that nominal GDP (that is, PY) can be used to represent total transaction values (PT) are obvious. GDP transactions are a subset of all transactions. The mainstream quantity equation that uses income or GDP to represent transactions will thus only be reliable in time periods when the value of non-GDP transactions, such as asset transactions, remains constant (thus dropping out when considering flows). However, when their value rises, this will cause GDP to be an unreliable proxy for the value of all transactions. In those time periods we must expect the traditional quantity equation, MV = PY, to give the appearance of a fall in the velocity V, as money is used for transactions other than nominal GDP (PY). This explains why in many countries with asset price booms economists puzzled over an apparent ‘velocity decline’, a ‘breakdown of the money demand function’ or a ‘mystery of missing money’ – issues that severely hampered the monetarist approach to monetary policy implementation.
    [end quote]

    The historically low interest rates lead to an increase in financial engineering. These transactions are non-GDP transactions. The money equation is MV = PQ = GDP. So V = GDP/M. Since M is increasing without an increase in GDP, then Velocity (V) decreases, as it must by arithmetical necessity. Which is exactly what it did, as can be seen in the FRED chart titled ” Velocity of M2 Money Stock”. The decline starts in the mid-1990s.

    1. I have written previously that the stock of money is complex and must incorporate your comment above. But essentially the stock of money will comprise unspent legacy value (unspent revenues) plus new credit money (temporary bank money) plus new permanent money (fiscal deficits and

  10. There is one confounding problem with this discussion on velocity. GDP refers only to final sales not total sales. Total sales is much bigger, but much of the intermediatery sales forming the difference is circulated by trade credit. This is why Marx distinguishes money as means of payment and as a means of circulation. Money as means of circulation exists primarily in the realm of personal consumption. Thus to obtain a true picture of velocity total sales must be adjusted by trade credit over a single period of circulation and the result used as the denominator against the stock of money. It’s complicated and above the pay grade of the FED.

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