The Root Cause of Inflation: Understanding Why it's High

The root cause of Inflation is the change in the ratio of money to the goods and services produced. The recent growth of the money supply has been massive and rapid. This coupled with a dramatic decrease in production and the resulting supply chain disruptions is the root cause of inflation.

Other factors, such as expectations, play a role in the timing and pace of inflation. However, it is misguided to ignore money supply and production to focus on secondary items. Inflation is a virtual certainty when the money supply increases enormously and production drops dramatically. Ignoring this fact sidetracks productive discussion.

The root cause of inflation. The chart shows the percentage change in the ratio of money (as measured by M2 money supply) compared to goods and services. From 3rd quarter 2019 through 1st quarter of 2022, the money supply grew 39.11% faster than goods and services. — Data: FRED Real GDP & FRED M2 Money Supply; Graph: Econ-Intel

Root Cause #1: Decrease in Production of Goods and Services

The world suffered a massive supply shock from “closing the economy” as a response to the coronavirus. For some items, there was capacity to catch up on production once the economy re-opened. For others, there were supply-chain issues or other issues that constrained future production as well. This depresses economic production and elevates input costs.

Chart showing the percent change in real GDP. Data goes back to 1947. It indicates that the largest drawdown was in the second quarter of 2020. Where GDP decreased 8.48% from the prior quarter. The next most dramatic decrease was 2.60% recorded in the first quarter of 1958. This decrease in production was one of the impacts that dramatically changed the ratio of money to goods and services and served as a cause of the subsequent inflationary period. — Data: FRED database; Graph: Econ-Intel

This was the largest single quarter decrease in real GDP in the FRED database that provides this data from 1947. Furthermore, this was not just a record decrease over this period. It dwarfed other contractions. This dynamic holds true over a single quarter, two quarters, three quarters, and a full year. The next most rapid periods of contraction were during the 1st quarter of 1958 when looking at both the single and two quarter decreases. For longer-periods the first and second quarters of 2009 we the closest to rival the 2nd quarter of 2020.

This chart shows a comparison of the largest drawdowns in real GDP evaluating 1, 2, 3, and 4 quarters periods of time. Over each of these periods, the 2nd quarter of 2020 was the most significant drawdown in the data series. Indicating a clear disruption in the quantity of goods and services and contributing to the subsequent period of inflation. — Data: FRED database; Graph: Econ-Intel

This table compares the second quarter of 2020, which was the most rapid declines in GDP from 1947 onward, to prior periods of GDP decline over the periods of 1, 2, 3, and 4 quarters. For the same evaluation period, the second quarter of 2020 was always two to 3 times higher than the previous record. The associated article discusses the role of this decrease as a root cause of subsequent inflation. — Data: FRED database; Graph: Econ-Intel

Root Cause #2: Increase in Money Supply

At the same time, the money supply increased massively. We analyzed the data for M2 money supply to find the fastest periods of money supply growth since 1959. 1959 was chosen as this is how far back M2 money supply data is readily available. We looked at twelve different timeframes, ranging from comparing the money supply to the prior quarter through 12 quarters prior. For every timespan, the most rapid period of money supply growth was in the 2020-2022 period.

The largest single quarter increase was from Q1 2020 to Q2 2020 where the money supply grew 13.39%. This is more than doubled the next most rapid quarter outside of the 2020-2022 period. Q1 1983 money supply grew 5.73% from the prior quarter. In other words, the rate of increase for Q2 2020 was more than twice as rapid as the prior record.

For every time-frame examined (1-12 quarters) this pattern held true. The highest rate of growth was from 2020 through 2022. So not only was the money supply growth incredibly rapid, it also persisted for an extended period of time.

Additional, all periods reviewed outside of 2020-2022, registering the rapid money supply growth were in the 1970s and early 1980s. Another period of elevated inflation.

This chart compares the rate of money supply increase over periods of 1 to 12 quarters between the 2020-2022 period and prior periods going back to 1959. 2020 to 2022 held the highest growth in the money supply for all 12 lengths of time evaluated. The growth in money supply was rapid and persistent and was a contributing factor to inflation that ramped up shortly afterwards. — Data: FRED database; Graph: Econ-Intel

Summing Up The Root Cause of Inflation

Money Supply:

Most rapid period of money supply growth was Q2 2020. More than 200% greater than any period outside of the 2020-2022.
All other timeframes from 2-12 quarters were also higher in the 2020-2022, than any other period. There were no exceptions. This period consistently was the highest money supply growth period.
All of the periods that came in 2^nd to the 2020-2022 period for money supply growth were in the 1970s and 1980s, another period exhibiting significant inflation.

Plummeting Production:

Production plummeted at the fastest rate seen in the data series going back to 1947. The single quarter decline was more than three times as severe as the next most significant decline which was recorded in 1^st quarter or 1958.
The decrease in production, lead to material shortages and supply chain disruptions that put downward pressure on production and increased production costs for a long-time and continue today.

Unique This Time:

This time BOTH a massive increase in the money supply and plummeting production occurred at the SAME time. In the past, all of the highest money supply growth periods were within the 1970s and early 1980s. While this period did have contractions, none of them ranked in our study of the most dramatic contractions. Those periods were in 1958 and 2009, depending upon the length of the time-period examined.

This time, by far the most significant (and a very persistent) increase in money supply was at the SAME time as the most abrupt decrease in production.

These factors together lead to an incredible increase in the amount of money available per unit of production. The logical result is inflation.

Stay in tune with the money supply and inflation as they evolve over time.

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