Why Inflation Chatter Is So Confusing: The Challenges of Additive Effects

Ben Lengerich
4 min readApr 4, 2023


The inflation/deflation debate is confusing. The fundamental challenge is that economic “inflation” is composed of multiple factors and different analysts like to focus on different factors without specifying their assumptions.

At a high level, we can model inflation as a change in the product of money velocity and money supply. Money velocity estimates how fast money is turned over, and increases in good economic times. Money supply estimates how many units of money exist, and is changed by government printing (deficit spending) and fractional reserve lending.

In the US, these forces have tended to act in opposite directions since 1990: money velocity has decreased while money supply has increased. As a result, inflation has not been a problem.

Money velocity has mostly decreased since 1990.
Money supply has mostly increased since 1990.

State-aligned economists (e.g. academics, large institutions) tend to believe they have control over the money supply¹, so they tend to be more concerned with the money velocity. In particular, they are concerned that velocity will decrease when financial conditions tighten. Thus, state-aligned economists are vigilant for signs of unexpected² deflation, because rapid deflation would indicate deteriorating financial conditions.

In contrast, dissident economists believe they do not have control over the money supply, so they tend to be concerned with the increase in money supply. They tend to view the increasing money supply as evidence of fiat debasement.

These divergent viewpoints are illustrated in predictions of the effects of quantitative easing (QE). QE is an asset swap in which a central bank buys treasuries from a private institution. Since the central bank is buying these bonds in a non-coercive manner, they must be paying a market-clearing value for the bonds, which increases bank reserves by imposing an upward force on the market price of bonds (and hence a downward force on the yields). Thus, QE de facto increases bank reserves. If bank reserves are included in our measure of money supply, then QE increases money supply.

However, the effects of QE on money velocity are not as clear because money velocity is influenced by what the bank does with their increased reserves. If the bank sees ample opportunities for lending out these increased reserves and acts on these opportunities, then money velocity may increase; on the other hand if the bank does not see opportunities for productive lending of these reserves, then the reserves sit lifeless on the bank’s balance sheet and money velocity decreases. As a result, QE is inflationary when economic conditions are good and has no effect on inflation when economic conditions are poor³. This makes QE somewhat like an ice cube of inflation — if the environment is cold, it will not increase liquidity; if the environment is hot, it will melt and produce extra liquidity.

In their search for power over money velocity, state-aligned economists tend to analyze QE by focusing on the “wealth effect”: increased asset prices can increase money velocity by psychological feelings of prosperity. Conversely, in their feeling of powerlessness over money supply, dissident economists tend to analyze QE by focusing on the increase in money supply. Both of these approaches can be misleading because the effects of QE are context-specific: when the economy is already good QE is inflationary, but when the economy is floundering QE does not have an inflationary effect.⁴

Finally, these divergent viewpoints have implications for understanding bond yields: state-aligned economists tend to believe that falling bond yields are an indicator of economic problems, while dissident economists tend to believe that increasing bond yields are an indicator of fiat debasement. Either of these could be correct interpretations, but they are only telling half the story. Bond yields are a composite measure of expectations of economic growth and fiat debasement; commentary that focuses on either of these measures independently misses half the story.

  1. In modern economies, most money is actually created by private institutions through debt creation. As a result, centralized institutions are often caught flat-footed by deflationary shocks in which the private institutions simultaneously reduce lending and remove liquidity. Since this is out of their control, centralized bankers are hyper-vigilant for signs of decreased lending.
  2. Forces that increase financial efficiency, such as technology and globalization, produce sustained deflationary effects. An economist’s expectation for the strength of these forces will change their baseline for expected levels of deflation.
  3. Recall that bond yields are growth + inflation expectations. If QE always lowers bond yields but is never deflationary, QE must decrease future growth expectations. This makes sense because QE increases asset prices in the present, decreasing future growth expectations.
  4. A good example of this is Japan, which has had a massive asset price bubble spurred by massive QE without much change in inflation.



Ben Lengerich

Postdoc @MIT | Writing about ML, AI, precision medicine, and quant econ