While listening to NPR this morning, I was subjected to yet another economist claiming that we cannot have inflation in an environment of such high economic slack. Setting aside the fact that perhaps this economist missed the 1970s, this is a vital question to examine, because it is the foundation of so much of Bernanke and the Federal Reserve’s current thinking. That is, the notion that inflation is always and everywhere the result of an over-heating, or excess demand, economy.

One of the measures commonly followed by the Fed, and others of the slack-restrains-inflation school, is the measure of capacity utilization rate. Setting aside some of the problems with this measure, are increases in capacity utilization associated with increasing inflation, as would be suggested by the slack-restraint school? It turns out not. Since 1967, when the data series begins, the correlation between capacity utilization and inflation, as measured by the consumer price index (CPI), has been negative. That is, as more and more industrial and economic resources have been brought into use, inflation has actually fallen, rather than risen (as would be predicted). A negative correlation also implies that low or falling capacity utilization does not mean low inflation.

Now what is positively correlated with inflation is the growth in the money supply. The chart below shows annual changes in both CPI and M2. Even just eye-balling the chart, one can see the positive correlation, which also shows up under statistical analysis.

Another question one often hears in today’s economic discussions is what would Milton Friedman say? I won’t claim to be able to channel Milton (or anyone else), but I do think the empirical evidence continues to support the conclusion that inflation is always and everywhere a monetary phenomenon.