The Independent Market Observer

11/14/13 – The Problem of Money, Part 3: Inflation Today and Tomorrow

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Nov 14, 2013 9:23:36 AM

and tagged Market Updates, Commentary, Economics Lessons

Leave a comment

Yesterday, we talked about how the money supply has not expanded unduly, given the level of economic growth. We also looked at credit growth and found that it too was running at or below the levels expected, considering the level of economic growth. There appears to be no sign of the Federal Reserve’s stimulus in these measures.

Does that mean we’re off the hook on inflation? The short answer is no, and the reason is interesting. First, though, a bit of background.

There are two components to how much money circulates through the economy. The first is the money supply and credit, which we just looked at. The second is how fast that money circulates. The faster the same amount of money moves, the more economic activity it generates. You can, therefore, have a growing economy and rising price levels with a stable money supply if the speed of circulation rises.

This speed is known, in the jargon, as the velocity of money. What makes it go up is a more efficient financial system, with banks and other financial institutions becoming more and more active, and lending becoming a more important part of the system. If you think about it, that pretty well describes the mid-2000s, and you would expect to see velocity rising over that time period. Moreover, you would also expect to see a correlation with inflation as velocity went up—and you do, in fact, see both, per this chart. Note the rise in money velocity and subsequent decline around the dot-com boom, as we will be coming back to this.

1As expected, the Consumer Price Index and money velocity are highly correlated, which makes intuitive and theoretical sense. You’ll notice, though, that this chart covers the period from 1992 to 2008. What happened since then, when the Fed started its stimulus programs?

2As you can see, the high correlation between the two reversed itself after 2009. Even as the economy slowed down, and velocity decreased by almost 50 percent, inflation continued. Think about that: even when one of the major factors driving inflation dropped significantly, it still went up. Why, and what happens when velocity increases again?

The why is relatively simple. The banks, severely wounded, pulled back on lending and cut available credit. Many consumers delivered. The money supply remained stable but generated less economic activity, and the banking contraction was the key to this.

What happens next is a bit more complicated. One way to look at it is to examine the last crisis, the dot-com bust, and see what happened to both money velocity and inflation then, as shown in the following chart.

3Here, we can see that velocity dropped sharply during the bust, moved sideways for a couple of years, then increased again, while inflation showed slower growth during the bust and then grew more quickly as money velocity picked up. (Also note that this was without the current extraordinary level of stimulus now being applied.)

The implication is clear: when money velocity recovers, it’s probable that inflation will accelerate as well. What could make velocity accelerate again, and is that likely in the short term?

I mentioned earlier that increased bank activity and lending acted to accelerate money velocity through the mid-2000s. The same happened in the capital markets in the late 1990s, as shown above. Like then, in the most recent crisis and since, the collapse in the financial and banking sector caused that relationship to reverse, and this has been a significant factor in the decline in velocity. Indeed, the Fed’s expansion of bank reserves is designed to allow them to lend more and bring velocity back up—which, again, is explicitly per the Fed’s goal of creating inflation.

We can now see that money is, in fact, more scarce than the raw numbers would suggest, once we take the slowing of economic activity, the money velocity, into account. We can also see what would cause that to reverse—increased lending by banks and an increasing money velocity.

The headline to keep an eye on, then, is bank lending levels. When they start to recover, so will inflation. In the dot-com bust, lending and money velocity began to recover about three to four years after the crisis. We’re now past that point, closing in on five years, and lending has started to increase again. Money velocity hasn’t begun to pick up yet, but it does appear to be bottoming.

Inflation is therefore very much alive. The Fed has not maintained scarcity of the currency, the weak economy has. And when the economy strengthens, which is happening now, scarcity will become increasingly, well . . . scarce. Keep an eye out, as a stronger recovery will be followed very soon by higher inflation.

Subscribe via Email

New call-to-action
Crash-Test Investing

Hot Topics

New Call-to-action



see all



The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.


Please review our Terms of Use

Commonwealth Financial Network®