Understanding the economy often requires logic, common sense, and rational deduction. However, these tools are only as effective as the information we have at our disposal and our ability to interpret it accurately. When there are gaps in data or knowledge, it’s easy to arrive at misleading conclusions. Particularly within the realm of economics, individuals must make choices based on incomplete information, leading to situations where appearances can be deceiving.
Consider the logic surrounding price inflation in relation to the Federal Reserve’s extensive $3 trillion balance sheet expansion over the past seven years. One might naturally conclude that an increase in money supply should lead to inflation, as more money competes for the same number of goods and services, logically resulting in price increases. This reasoning could easily prompt someone to sell their dollars and invest in gold, believing it to be a well-founded strategy.
While this conclusion seems reasonable if one only focuses on part of the Quantity Theory of Money—specifically the notion that more money leads to higher prices—one important aspect is often overlooked.
The Other Part of the Equation – Velocity
The often-neglected element is the velocity of money, which reflects how quickly money circulates within the economy. If the supply of money grows but the velocity decreases, then monetary stimulus efforts become ineffective. For instance, if a mechanic spends $40 on supplies from a store owner, who then spends that same money to have his car repaired by the mechanic, and the mechanic eventually uses part of that money to buy groceries, then $100 has effectively changed hands. Yet, this is grounded in just $50 of actual money because each dollar was exchanged multiple times, resulting in a velocity of 2 transactions per day.
Conversely, if the store owner stashes the $40 in a mattress and the mechanic decides against spending his earned $50, total spending drops to just $40, and the velocity effectively halves. This scenario illustrates how a lack of circulation can severely diminish economic activity.
Money Velocity Lethargy
The critical takeaway is that though the money supply has expanded significantly in recent years, the velocity of money has stagnated. This sluggishness could explain why consumer price inflation, as reported by the Bureau of Labor Statistics, remains nearly nonexistent. Additionally, it may clarify the decline in gold prices, which plummeted from a peak of $1,900 an ounce in 2011 to roughly $1,075 today—a drop of over 43 percent.
Like interest rates, price inflation and money velocity often move in extended, cyclical patterns. For instance, when inflation peaked at 14 percent in 1980, the velocity was approximately 3.5. Since then, inflation has steadily decreased to around 0.2 percent, while the velocity has dipped to below 1.5.
Thus, despite the substantial increase in the Fed’s balance sheet since 2008, both price inflation and economic growth have been tepid. A critical missing factor is the sluggish velocity of money circulation. Until this changes, the Fed’s stimulation efforts will face significant hurdles.
In other words, unless money velocity accelerates, increases in the Fed’s balance sheet will fail to inject greater liquidity into the economy. Cheap credit will remain sequestered within bank balance sheets, leaving financial institutions to hoard it or invest in government debt.
As such, the money supply can struggle to circulate at a pace fast enough to elevate prices or encourage demand. Policymakers recognize this issue, yet publicly, they seldom acknowledge it.
In future economic downturns, they might shift focus to enhancing the velocity of money. Possible strategies could include initiatives like “QE for the people,” where the Fed generates funds that the Treasury distributes directly to citizens. Alternatively, instituting negative interest rates might incentivize banks to lend rather than hold money, reducing the appeal of savings and cash hoarding.
Ultimately, the velocity of money may someday rise as long-standing cycles eventually reverse. Public sentiment can shift over time; individuals may grow wary of efforts that devalue their money, prompting them to spend it more readily. When this shift occurs, we could see a rapid increase in money velocity, which, in turn, would elevate prices across the board.
At that moment, managing such inflation could become a daunting challenge for the Fed.
Sincerely,
MN Gordon
for Economic Prism
