The Inflation Puzzle

CAMBRIDGE – The low rate of inflation in the United States is a puzzle, especially to economists who focus on the relationship between inflation and changes in the monetary base. After all, in the past, increases and decreases in the growth rate of the monetary base (currency in circulation plus commercial banks’ reserves held at the central bank) produced – or at least were accompanied by – rises and falls in the inflation rate. And, because the monetary base is controlled directly by the central bank, and is not created by commercial banks, many believe that it is the best measure of the impact of monetary policy.

For example, the US monetary base rose at an annual rate of 9% from 1985 to 1995, and then slowed to 6% in the next decade. This decelerating monetary growth was accompanied by a slowdown in the pace of inflation. The consumer price index (CPI) rose at a 3.5% rate from 1985 to 1995, and then slowed to just 2.5% in the decade to 2005.

But then the link between the monetary base and the rate of inflation was severed. From 2005 to 2015, the monetary base soared at an annual rate of 17.8%, whereas the CPI increased at an annual rate of just 1.9%.

To explain this abrupt and radical change requires examining more closely the relationship between the monetary base and inflation, and understanding the changing role of the reserves that commercial banks hold at the Federal Reserve.