Forget the Trump tax cuts, the Senate budget deal, the Fed’s Quantitative Tightening and the collapse in foreign buying of US Treasuries: after years of dormancy, the biggest catalyst for a sharp inflationary spike has finally emerged, and it is none of the above. Behold: the velocity of money.
Over the past decade we have shown this chart on numerous occasions and usually in the context of failed Fed policy. After all, based on the fundamental MV = PQ equation, it is virtually impossible to generate inflation (P) as long as the velocity of money (V) is declining.
None other than the St. Louis Fed discussed this in a report back in 2014:
Based on this equation, holding the money velocity constant, if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference. According to this view, inflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent. Why, then, has inflation remained persistently low (below 2 percent) during this period?
The issue has to do with the velocity of money, which has never been constant. If for some reason the money velocity declines rapidly during an expansionary monetary policy period, it can offset the increase in money supply and even lead to deflation instead of inflation.
The regional Fed went on to note that during the first and second quarters of 2014, the velocity of the monetary base was at 4.4, its slowest pace on record. “This means that every dollar in the monetary base was spent only 4.4 times in the economy during the past year, down from 17.2 just prior to the recession.
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