My Last Post on Monetary Policy...For Now...I Hope

In all media outlets, the same topic is being discussed as nauseam: inflation. Inflation? Yes. Interest rate cuts/hikes, the depreciating dollar and relatedly oil price appreciation all speak to monetary policy, which is but one small step removed from inflation. Remember, the Fed's mandate is to strike a balance between economic output/growth and a stable price level.

What I keep coming back to is Milton Friedman's famous assertion that "inflation is always and everywhere a monetary phenomenon." For there to be a general rise in the price level, there must be either growth in the aggregate money supply (M2, M3, whatever), a spike in the velocity of money (think turnover), or both.

With me so far? Good.

Now let's suppose there's a fundamental shift in a key commodity market. Say, oil. All of the sudden, the world realizes China is on an oil bender (the data actually do not say this...yet) or some other plausible story catches the attention of market participants. As a result, the equilibrium price of oil goes up (in the spot market, let's ignore futures). Oil and its derivative products are a key input to our economy (blatantly obvious). Surely an increase in gas prices will boost inflation, right?

Well, let's go back to Milton. Inflaiton is a monetary phenomenon, the overall price level will climb only if more money is pumped into the system. This relationship is separate and distinct from relative price movements among goods/services. In other words, if oil prices go up, consumers will curtail gas purchases. If real estate prices drop, renters might decide to purchase housing assets. What I've described is a reallocation of dollars, a new way to slice the pie. But I haven't said anything about growing (or shrinking) that pie.

Inflation scares me as much as the next guy, don't get me wrong. But I belive discussions regarding the CPI (or any of the other myriad measures of inflation) would sound a lot less dire if we put the matter in its proper (ie, monetary) context. Remember, the CPI was created as a proxy to read changes in the aggregate money stock.