Gold, Inflation, and the Velocity of Money Part I
Beware the Inevitable Unleashing of Massive Fed Liquidity
Before the presidential election, Blanchard and Company, Inc., predicted gold would reach $3,000 within the next four years regardless of who was elected, but that it would do so even faster under President Obama, whose principal appeal to the electorate is based on the concept of redistributing wealth from rich to poor, creditor to debtor. Obama can accomplish that redistribution in three ways: 1) higher income taxes, 2) expansion of entitlement programs, and 3) monetary devaluation and inflation. So far we have seen higher income taxes and expansion of entitlement programs. However, how will that devaluation and inflation take place?
Since the financial crisis of 2008-09, the Federal Reserve has injected unprecedented amounts of liquidity without producing any remarkable increase in inflation or decrease in the value of the dollar. As economist Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.” Then why has this global monetary infusion – or Great Reflation, as it has come to be called – been unable to produce the expected inflationary boom? If inflation is an increase in money and credit beyond the growth requirements of the economy, then why don’t we see inflation, or even hyperinflation, today?
The answer is that the direction of monetary growth does not necessarily dictate the expansion or contraction of the economy, which is also dependent upon the velocity of money, a measurement of how fast the money injected into the system by the Fed transacts or, as the chart below indicates, “the rate of turnover in the money supply – that is, the number of times one dollar is used to purchase final goods and services included in GDP.”
The Velocity of Money
Today the rate of monetary velocity, which is lower than it was during the Great Depression, is declining even further, offsetting the potentially positive impact of recent rapid money supply growth. If the velocity of money were to revert to a more normal level, money supply growth would clearly have a far greater stimulative effect on the economy.
The necessary question is, “Where did all the money growth go?” The answer is that the Fed’s bond-buying program known as quantitative easing essentially pours money into the banks and other financial institutions, which then use it as they see fit. Instead of spreading that money into the economy, the banks have built up massive excess reserves and cash assets. Keeping that gargantuan amount of money on their balance sheets, as the chart below shows, is the primary culprit – the reason why rapid monetary growth has failed to produce either inflation or economic growth.
An example can be found in the banks’ approach to mortgage credit. In large part because of bargain-basement interest rates, the U.S. is experiencing something of a recovery in the housing market. However, those near-record-low interest rates are often unavailable to the average home buyer. Only the least risky buyers have access to mortgage credit, leaving millions of buyers unable to take advantage of Fed policies that have reduced financing costs. The result? A sluggish velocity of money – and equally sluggish economic recovery.
This monumental decline in the velocity of money is restraining inflation, as it logically would. If the velocity of money reverses to a more normal level, money supply growth will clearly have a far greater stimulative effect on the economy. However, it is not something that we can take comfort in with respect to inflation expectations. We should be worried about what happens to inflation when the velocity of money begins to rise along with the money supply. Money velocity is now lower than it was during the Great Depression, leaving us to the conclusion that it has no place to go but up.
This would trigger a frightening scenario. If velocity increases rapidly, it will cause a sharp increase in inflation. If inflation rises sharply, it will bring about a rapid increase in velocity. Both of these make perfect sense: The faster prices are rising, the faster people spend their money, because they want to make their purchases before prices rise further. The faster people spend their money, the faster prices rise.
Faster economic growth is a condition for sustained major inflation problems, but inflation does insist that an improved economy will cause a tightening in policy on the part of the developed countries’ central banks. But wait. Central banks and the entire political processes of the developed countries have shown an alarming inability to execute the policies that are called for at the moment. In fact, political dysfunction practically ensures that when rapid growth finally returns, central bankers will have neither the will nor the tools necessary to contain inflation.
“I’ve always believed that America’s government was a unique political system – one designed by geniuses so that it could be run by idiots. I was wrong. No system could be smart enough to survive at this level of incompetence and recklessness by the people charged to run it.”
Thomas L. Friedman, “Rescue the Rescue”
The New York Times, Sept. 30, 2008
Even members of the Federal Reserve Board itself have come to admit there is much they don’t understand about the impact of monetary policy on the U.S. and global economies. “We’re at the limits of our understanding of how monetary policy affects the economy,” Richmond Fed President Jeffrey M. Lacker told The New York Times on Jan. 13, 2013.