The recent stock market volatility was largely blamed on fears of inflation, or at least that is what stock analysts and the media told us. They were setting aside any real possibility of characterizing the decision criterion of a couple hundred million individual trades, especially when some stocks will benefit from inflation. Still, the issue of stock prices and inflation is worth some reflection.

It’s best to begin by explaining that inflation is always and everywhere a phenomenon of money supply. A necessary, but not sufficient, condition for inflation is the presence of more money than is needed to support the trade of goods and services. The equation of exchange is a good, old-fashioned way to think about this. In the equation of exchange P*Y = M*V; or the price level (P) times current production (Y) must be equal to the money supply (M) times the velocity of money (V, frequency that money circulates through the economy). If M increases, but V stays the same, then either P or Y must rise to maintain this equality. Because Y (current production) is determined by how much people actually produce, the price level (P) must be the variable that shifts. That, in a nutshell is inflation as a theory.

In practice, there are many constraints to an increase in the price level, otherwise known as inflation. The money supply could be very large but held by banks or the Federal Reserve. This would prevent the oversupply of money from directly affecting prices. Also, it is possible that current production is in recession, so the increase in money would send signals to firms to produce more goods and services. That is a trite simplification of Keynesian macroeconomics. A third impediment to inflation may be a set of institutions or behaviors that prevents price or wage increases, the visible signs of inflation. Businesses may not feel they can increase prices, or workers may not ask for wage increases or be willing to relocate to find better paying work.

All three of these factors may be at work today, in keeping inflation fairly low. Indeed, the historically fast growth of the money supply during the Great Recession caused many in the economics profession to worry publicly about inflation. I did as well, underestimating the persistence of the constraints to higher prices. So, we have enjoyed rather tame inflation for many years, while sitting atop a money supply that could sustain double-digit inflation for many years. And that turns us to a plausible explanation for the stock market volatility.

The broad US stock indices have been enjoying a lengthy and stable period of growth. The January jobs report, which reported modest wage increases, may have interrupted that tranquility. Those wage gains are good for the economy, and for individual workers and their families. They may also signal the beginning of inflation. This would cause the Federal Reserve to tighten the money supply, which is exactly what they have been doing for two years. There is nothing unexpected about that to cause turbulence in financial markets.

The very large supply of money is worrisome, but not because it might lead to inflation. In fact, some modest inflation might be a helpful ointment to parts of the economy that have yet to recover from the Great Recession. Rather, the worry is that it is so very hard to predict the speed with which inflation may occur. Right now it is nearly invisible, but the money supply today is between two and three times the 2007 level. This could sustain a period of exceptional inflation, met by exceptional policy responses by the Federal Reserve. This would certainly slow the economy from its already paltry rate of growth.

The trouble with stock markets is that we do not, and maybe cannot predict when or by how much inflation will occur. We can only say that it will occur, which is not an especially useful prediction. Moreover, given how poorly we economists forecasted inflation in the wake of the Great Recession, there should be little confidence in our forecasts on timing and magnitude today. This is true of Wall Street, industry, and academic economists alike. And all this makes me think that the volatility on Wall Street is a response to uncertainty rather than inflation. Few stocks would benefit from uncertainty. If that is so, we should expect much more of it in the months to come.