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.
As 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?
As 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.
Here, 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.