Inflation Is Neither Transitory nor Caused by QE
Inflation is soaring around the world. There’s a great debate between the inflationistas and the transitorians over why. Is supply chain disruption or the money supply behind the ‘surprise’ increase in prices?
It’s becoming a crucial question to answer. Indeed, the surge in inflation is only accelerating, with a 5% inflation print in the US and German producer prices rising the most since 1951 — 18%.
If supply chain chaos is the cause, then monetary policy must remain loose to help the economy deal with higher prices. If QE is the cause, monetary policy must tighten to prevent inflation from spiking any further.
So which is it?
Neither. But back to that in a moment. First, let’s hear out the two sides.
On the one hand, we have the central bankers who claim that the world’s present bout of inflation is caused by temporary supply chain issues. Tightening monetary policy now would be an overreaction that risks triggering a crisis.
On the other hand, we have the inflationistas, who see every increase in the money supply as inherently inflationary. Central banks should hit the breaks or else risk inflation rising out of control.
At this point, it’s important to note that economics is not a linear science art. It’s not like physics, where doing the same thing delivers the same outcome each time.
Central bankers thought that QE could be done infinitely without causing inflation because it hadn’t caused inflation for about 13 years. Repeating the same thing should lead to the same outcome — rising stocks and no inflation.
However, economics is like physics in that it offers plenty of phase transitions. Not much happens to water between 0°C and 99°C. But a degree higher or lower and all of a sudden, a lot happens. This is a phase transition.
And the same may have happened for inflation. That little bit too much QE triggered a fundamental change in the relationship between the money supply and prices.
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Just as the inflationistas had warned, eventually, the central bankers overdid it. Hence the prohibition on using QE passed down by our forefathers. Remember when it was taboo?
While I agree with this point of view, it’s missing what’s far more important.
And so today, I’d like to discuss why both sides have it wrong. Neither the money supply nor the supply chain disruptions are to blame for our present bout of inflation around the world.
Instead, there’s a very different factor. One which no central banker or supply chain manager has control over. It’s called the velocity of money.
The velocity of money refers to how fast, or often, money is spent.
If money goes from being spent just once a day to twice a day, it feels like there is twice as much money sloshing around the economy. The money supply hasn’t increased, but it feels like it has doubled.
The velocity of money is what has changed in this example. The speed or frequency with which money is spent.
Here’s the reason I’m raising the velocity of money right now. During the pandemic, velocity plunged. We weren’t able to spend or borrow as much money because of all sorts of restrictions. Savings rates went up too.
This means that the vast increase in the money supply from QE was offset by plunging velocity. Or rather, the other way around. Central banks were able to offset the plunge in velocity by creating more money.
But what happens as the world begins to return to normal? Then the velocity of money will begin to normalise too…
From pandemic levels, this means a rapid rise. Even if it isn’t to high levels, the point is the direction of change.
For the past few decades, the velocity of money has been falling, acting as a headwind for inflation. This allowed impressive amounts of money creation to happen without inflation spiking.
But in coming months, as velocity spikes, all that money supply will suddenly begin to circulate.
And nobody can control this shift. Short of capital controls or lending restrictions, that is.Velocity is not subject to government policy like the money supply.
Here’s what you really need to understand about the velocity of money…as you can imagine, when inflation begins, people try to spend their money faster. They try to get rid of it quickly to avoid the loss of value from holding it.
This means the velocity of money speeds up when inflation begins. Which, in turn, makes the same amount of money feel like even more money. And that only accelerates the inflation even more.
Once the fuse is lit and inflation and velocity feed off each other, the stage is set for rapid inflation.
Of course, central banks could reverse QE and drain money out of the economy to offset rising velocity. But I doubt they could do it without triggering a crash in asset prices.
The point being that the current inflationary spurt may be caused by, and may continue unexpectedly, because of a factor which isn’t getting any media or investor attention, and can’t be controlled by governments or central banks.
The velocity of money will be the sub-prime mortgage of our coming inflationary crisis.
Until next time,
Editor, The Daily Reckoning Australia
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