Years of Poems and Spirits

WSJ had this article: Cheap Money Doesn’t Explain Market Puzzles (c).

Very interesting view point:
“Liquidity is an ex-post justification for why markets are going up,” Mr. Edwards says. “There’s lots of liquidity around — well, there always is until there isn’t, and then it just disappears.”

Boy, what an insight.

If this guy is on to something, monetary policy is more of a signaling tool than a direct instrument. It may sound a little far fetched but I think there is some truth to it.

First of all, does inflation still mean the same today as 30 years ago? Secondly, is CPI a good indicator of market price level? More specifically, is CPI a good indicator of price level as a result of money supply? Third, my hypothesis is that inflation is the result of a large gap between level of consumption and productivity. In other words, inflation happens if productivity cannot sustain a certain level of consumption–etiher because of overconsumption or a sudden decline of productivity.

An example would be the oil price spike during the 1970s. Oil’s high consumption level was supported by its low price. However, the disruption of supply caused a sharp drop of productivity (because of the spike of capital cost). It is as if a worker used to use a bucket of oil to produce a good now he has to use a bucket of gold to produce the same thing.

Therefore, inflation is not (always) the result of excess liquidity. If this is true, then monetary policy may not work as planned during inflation. Only when consumption level and productivity reconverge (e.g. new technology suddenly increases productivity or consumption is sufficiently depressed, or both) would inflation go away.