Inflation and the Relative Value of Money

Abstract

An alternative formula to the Quantity Theory uses monetary aggregates to measure changes in the value of money which explain virtually all variation of future long-term inflation, enabling significantly more accurate inflation forecasts than consensus with important implications for monetary policy.The Formula provides a statistically significant explanation of future inflation in all 18 countries surveyed. Over 94% of the variation of long-term inflation is explained in 13 of the 18 countries – Australia, Canada, India, Japan, Mexico, New Zealand, Norway, South Africa, Sweden, Switzerland, the U.K., and the U.S. Out of sample forecasts for U.S. inflation are 50-70% more accurate (smaller error) than consensus long-term forecasts and 10-20% more accurate than Green Book shorter-term forecasts.Inflation Elasticity is derived – the amount of monetary growth necessary to increase inflation. Inflation Elasticity becomes increasingly inelastic at geometric rates. As a consequence, during the U.S. Quantitative Easing program, inflation was fifty times less sensitive to monetary stimulus than at the onset of the Great Inflation. The inability of central banks to hit inflation targets is a feature, not a bug, of advanced economies. Similarly, the probability of sustained, long-term deflation is minimal. Monetary stimulus in advanced economies is now more likely to produce bad debt than to boost inflation.The Financial Crisis is an unfortunate example of these characteristics – the fastest growth to that point of the Federal Reserve’s balance sheet resulted in little inflation and large amounts of bad debt.