Milton Friedman famously said of inflation that it is “…always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” However, over the last five decades we have witnessed a persistent disparity between the Consumer Price Index (CPI) and the quantity of dollars (M2).  

This first graph shows the value of $100 in 2024 as of certain points in the past. While it’s dispiriting to think that the dollar has lost 87% of its value since 1971, the more important difference is between inflation measures. M2 should have indicated a much higher inflation rate than CPI displays. Why is this?

We believe some combination of factors have converged to bring this about. 

Factor 1: CPI is a bad statistic. “Core CPI” famously strips out the changes in food and energy prices. The given reason is that those expenses tend to be very volatile, thus skewing price changes in all other reported goods and services. Both food and energy are nonetheless large personal expenditures and thus highly relevant. We’re willing to give the Bureau of Labor Statistics a break and assume that inaccuracies in CPI are due to inherent limitations. Still, it’s the case that CPI is not synonymous with inflation but is rather only one way of describing inflation’s impact on consumers.  

Factor 2: It’s just output. Friedman’s quote describes a relationship between the rates of change in the quantity of money and in economic output. If CPI is an accurate measure of inflation and its annual rate of increase is persistently below that of M2, then output must be growing. The formula for economic growth = efficiency gains + labor force growth. For much of the last 50 years both computing power (efficiency gains) and the rise of women in the workplace (labor force growth) have provided strong tailwinds for output.  

Factor 3: New demand for dollars. The second graph shows the year-over-year changes in M2 and CPI. 

Conventional wisdom suggests that the end of the Gold Standard in 1971 also brought about the end of the Bretton Woods Agreement. Bretton Woods was a postwar monetary regime which relied on the U.S. dollar being backed by gold, in order that other nations could comfortably peg the value of their currencies to the dollar. In fact, what began to happen in 1971 – and especially after the oil embargo in 1973-74 – was that oil replaced gold as the basis for the dollar. This phenomenon is expressed as the “Petrodollar System.” In exchange for guarantees of military protection and equipment sales, Saudi Arabia agreed to price oil in only dollars. This created a persistent demand for dollars as a global reserve currency and Treasury bonds as global reserve assets. In time, several other OPEC countries joined Saudi Arabia in this arrangement.  

Where Does that Leave Us? 

The major question related to Factor 2 above is where does the U.S. go now for economic growth through either efficiency gains or labor force growth? The primary question related to Factor 3 is will oil producing nations continue to price their output in U.S. dollars, or might they prefer to develop another purchase and settlement method. If the answer to either or both of those is “no”, we would expect to see a much tighter relationship between CPI and M2 in the years ahead.  


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