The equation of exchange shows the relationship between the money supply, velocity of money, price level, and real GNP. This equation is a tautology that no competent economist would argue against.
Money-supply * Velocity-of-money = Price-level * Real-GNP
On the scale that we are currently increasing the money supply, the real GNP is basically constant. Inflation can be thought of as too much money chasing too few goods. When looking at a 400% change in the base money supply over the last 5 years, the change in real GNP (change in goods) is so small that we won’t be off much by ignoring it. To help understand this short period of time with a big change in the base money supply, we can make a simplified version of the equation of exchange.
Money-supply * Velocity-of-money = Price-level * constant
If the velocity goes down as the money supply goes up, it is possible to increase the money supply without changing the price level.
Hussman has shown that as interest rates go down the velocity of money goes down and as interest rates go up the velocity of money goes up.
At first when the Fed makes new money and buys bonds, they increase the price of bonds, which means they lower the interest rate. Hussman’s data shows this lowers the velocity of money. The lower velocity can compensate for the increased quantity of money so that often new money does not cause inflation right away.
The equation of exchange can be used with whichever definition of money supply you want to use (base money, M1, M2, etc). It is most clear that inflation will come if we use base money as our definition of the money supply. The base money supply has gone up by around a factor of 4 in about 5 years.
Since we have so far avoided inflation, the velocity of base money must have gone down by about a factor of 4 during this same period. The way this happened is that most of the new base money the Fed has made has just sat still in the Fed as excess reserves. This huge amount of non-moving money lowers the overall average velocity of money. If you think about it, it makes sense that making new money that does not leave the Fed should not cause inflation. Paying higher interest on excess reserves than short term bonds were paying was Bernanke’s great new trick to hide a few trillion dollars out in the open.
From Hussman we should expect the velocity of money to go up as interest rates go up. From the simplified equation of exchange, when the velocity of money and the money supply are both going up we should expect inflation.
As interest rates return to normal levels, the velocity of money will also return to normal levels. Then we will have 4 times the money supply and a normal velocity of money. By the simplified equation of exchange, we will then have 4 times the price level. We will have very high inflation.
You may be wondering, “why can’t the Fed hold interest rates down forever?”. Good question. If inflation is higher than the interest rate, then everyone and their brother can make money by borrowing and buying random stuff. To hold rates down the Fed would have to make an ever increasing amount of money, resulting in ever increasing inflation and ever increasing borrowing. The Fed seems interested in tapering their money creation which will mean letting interest rates go up. Japan, at least for the moment, seems to have chosen to try to hold interest rates down no matter how much money creation it takes. Once government debt and deficit are out of control, there is no good path for the central bank.
For the velocity of money to return to normal, it is reasonable to expect the excess reserves at the Fed will enter the real economy. There are those who think these excess reserves are somehow trapped but a bank with excess reserves can send an armored truck to the Fed and withdraw paper Federal Reserve Notes with no restrictions on them. This could happen at any time and possibly very suddenly. A couple trillion dollars suddenly flowing into the real economy would clearly result in high inflation.
Even Krugman has said that increasing the money supply is only safe when interest rates are near the zero lower bound. With interest rates going up, even by Krugman’s logic, we should expect inflation.
Here is another way to look at it. From 1913 to 2007 the Fed made about $800 billion in new money total. Since then it makes around that much each year. Nearly 94 years worth of money every 12 months. In this environment, one should expect to see “too much money chasing too few goods”.
Another way to look at it. In order to not cause inflation the central bank would need to be able to withdraw all the new money they created. There is just no way this can happen. Interest rates would shoot up, the value of the bonds the Fed held would crash, and they could not sell them for enough to withdraw as much money as they created.
High inflation will come. It is just a question of when.
Editor’s Note: The author’s views and conclusions in the above article are unaltered and no personal comments have been included to maintain the integrity of the original post. Furthermore, the views, conclusions and any recommendations offered in this article are not to be construed as an endorsement of such by the editor.
*http://seekingalpha.com/article/2451485-how-we-know-high-inflation-is-coming?ifp=0 (© 2014 Seeking Alpha )
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