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Is Inflation a Psychological or a Monetary Phenomenon?

NEW YORK ( TheStreet) -- Over the years, many things have been wrongly cited as inflation drivers. High resource costs, low unemployment, high oil prices, extreme weather and even an economy with healthy demand have been falsely accused at times.

That list of unwarranted scapegoats got a new member last week, when an IMF report suggested inflation may be tied to ... inflation expectations.

Here's the logic. According to the report, because people generally have confidence in their central bank's ability to meet its self-imposed inflation target over time, future inflation expectations are more a function of the central bank's target than the current inflation rate, and this is somehow a self-fulfilling prophecy. And, as a corollary, when inflation expectations become "disanchored" from the target -- when expectations are materially higher -- that, too, is self-fulfilling.

Problem is, this assumes inflation is always and everywhere a psychological phenomenon. Yet evidence overwhelmingly shows inflation is a monetary phenomenon -- too much money chasing too few goods.

Inflation's driven by money supply, money velocity and the supply of goods and services, and none of those is a psychological thing. Money supply is driven largely by central banks and cross-border capital flows. Money velocity is largely a function of bank lending -- if banks lend more, businesses have more capital to spend on new technology, equipment and the like, and that money gets re-spent again and again. If banks lend less, money moves more slowly. The third variable, supply of goods and services, is also fundamental. Infrastructure bottlenecks, import caps, price controls and the like can all cause supply shortages, which drive prices higher.

Brazil provides a timely example of this. In recent months, supply chain bottlenecks, fuel and energy price controls, import restrictions and high industry-specific taxes have hurt production, broadly limiting the supply of goods available.

Compounding matters, the government's haphazard efforts to boost the economy -- currency intervention, "Buy Brazilian" policies, forcing down bank lending rates and offering one-off tax incentives for various industries -- have stymied private investment.

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