Milton Friedman famously observed “inflation is always and everywhere a monetary phenomenon.” This aligns with simple intuition—if money is printed too rapidly, then the prices of goods and services will surely rise.
The Federal Reserve is presently expanding the monetary base at an unprecedented pace. But inflation, at least as reported by U.S. government statisticians, appears to be modest (more on reported inflation statistics in future blogs). How do we explain this apparent anomaly?
As was previously discussed in our March 4, 2013 blog, one relevant factor pertains to the difference between the monetary base and the money supply. It is the monetary base that is directly impacted by the Federal Reserve’s ongoing policy of purchasing boatloads of government bonds. The monetary base consists of bank reserves and cash in the hands of the non-bank public. But expanding the monetary base does not necessarily correspond to expanding the money supply. The money supply (M-1) consists primarily of checking account balances and cash held by the non-bank public. An expanding monetary base may not result in more checking account balances in an environment where commercial banks are reluctant to loan and are holding lots of excess reserves. And the Fed’s policy of paying banks interest for clinging to reserves is having a negative impact on bank lending. Thus, the money supply is not growing nearly as rapidly as the monetary base.
Still the money supply is growing. For the 12-months from January 2012 to January 2013 the money supply (M-1) grew at an annual rate of 11.8 percent, while (M-2) grew at 7.5 percent (source: http://www.federalreserve.gov/releases/h6/current/). So, why is there little (reported) inflation?
The equation of exchange, explained fully in Capital as Money, provides us with an answer. The equation of exchange relates the money supply (M), the velocity of money (V), the average price of a good or service (the price level, P), and the physical units of output produced in our economy (real GDP, Y). The equation is a simple identity, and is shown below:
M V = P Y
At the present time our money supply, as measured by M-1, is growing at about 12 percent per year. Meanwhile, real GDP (Y) is sputtering, with an annual growth rate of about 2 percent. Likewise, reported inflation is somewhere in the neighborhood of 2 percent. What is going on? The answer is found in V, the velocity (or turnover) of money. The velocity of money represents the number of times a dollar is spent on goods and services during a year. And it has been declining. A rapidly falling velocity of money can offset any increase in the money supply. An examination of the equation of exchange suggests an economy will experience falling nominal GDP (which is P Y on the right-hand-side) whenever velocity (V) is going down more quickly than the money supply (M) is going up.
Now, here is the problem with velocity: It always tends to go the wrong direction. When an economy is entering recession prices tend to fall, and people are motivated to hoard their money. Holding on to your cash makes a lot of sense if prices are going to be lower tomorrow than they are today. This tendency can be seen in data provided by the Federal Reserve Bank of St. Louis (http://research.stlouisfed.org/fred2/categories/32242). The velocity of money M-1 as of the fourth quarter of 2007 stood at 10.367. By the fourth quarter of 2008 it fell to 9.202, and has steadily declined since. As of the fourth quarter of 2012 the velocity of M-1 is a lowly 6.547. The declining velocity has been sufficient to offset a growing money supply, resulting in rather tame reported inflation.
As was stated above, forces are at work to make velocity move in the wrong direction. When inflation heats up, it entices people to spend money more quickly. After all, who wants to hold cash when prices are rapidly rising? Better to quickly spend your money on real goods and services; don’t wait until you have to pay more.
Right now inflationary expectations seem to be modest, and people are willing to hoard cash. When inflation appears—and it will—the mindset will reverse. Rising prices will trigger a rush to spend, and velocity will go up. The rise in velocity further reinforces rising prices, which again increases velocity, and so on. Such is the nature of an inflationary spiral.