Why Inflation Is MIA

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"The amount of money in the US economy is 25% higher than it was at the start of 2020, eclipsing any pace of money growth seen since the Federal Reserve was established (1913)"
Richard Bernstein Advisors Deputy CIO Dan Suzuki

In recent weeks, we have seen a non-stop flow of ominous statements like the one above.

The author is 100% factual and it should be a cause for deep concern. Historically, such surges in the money supply were often met with significant inflation. But inflation has been missing in action because there has been a corresponding collapse in the velocity of money.

While the sharp increase in the money supply provides context to the depth of our economic problems, our inflation warning bells are not ringing, at least not yet. Here is why.

What is inflation?

Inflation, or aggregate price increases, results from economic activity along with the amount of money and its velocity.

A famous economic formula called the monetary exchange equation uses those factors to create a mathematical identity that precisely determines the inflation rate.

I co-authored an article with Brett Freeze entitled Stoking The Embers of Inflation. The article went into great detail about the monetary exchange equation. I summarize a few key points here:

Per the inflation identity, the rate of inflation or deflation (%P) is equal to the rate of money growth (%M), plus the change in velocity (%V), less the rate of output growth (%Q).

%M – As noted earlier, the change in the monetary base is a direct function of the Fed’s monetary policy actions. To increase or decrease the monetary base, the Fed buys and sells securities, typically U.S. Treasurys and more recently mortgage-backed securities (MBS).

%V – Velocity is nominal GDP divided by the monetary base (Q/M). Velocity measures people’s willingness to hold cash or how often cash turns over. Lower velocity means that people are hoarding cash, which usually happens during periods of economic weakness, credit stress, and fear of banking institutions' stability.

If we exclude GDP, inflation is dependent on money supply and velocity changes. Money supply data is published weekly and easily forecastable with the Fed’s QE schedule. Velocity, on the other hand, is posted once a quarter and much more challenging to forecast. As such, let’s dive into velocity.