Ed Peters
November 3, 2021

Last week, we received another bit of data that may explain the Fed’s reluctance to raise US rates, despite persistently high inflation. Milton Friedman famously said that inflation is everywhere a monetary phenomenon. So monetarists usually quote excessive growth in money supply as a precursor to inflation. But Japan has experienced high money supply growth for decades without inflation. Here in the US, we had money supply growth after the Global Financial Crisis (GFC) of 2008, but inflation stayed stubbornly low. So what’s been missing?


The velocity of money (the ratio of quarterly GDP to money supply) in theory estimates how much money is being used for consumption vs. savings. Monetary inflation occurs when too much money is chasing too few goods. So, if the money supply isn’t growing faster than the economy is growing, we don’t have the money supply/velocity tango that characterizes monetary inflation. That has been the case in the US, where M2 velocity, based on less liquid money, has been steadily declining since the GFC. After the massive stimulus to fight the economic shutdown of 2020, M2 money supply soared, but M2 velocity dropped to a new low. As of the third quarter number released last week, velocity has yet to recover, despite the continuing rise in M2. The same is true for M1 velocity, related to the most liquid assets. While a shortage of goods is the likely reason consumers are saving rather than buying, it also means that inflated prices are not being caused by an inflated money supply. This time, inflation may not be a monetary phenomenon because velocity is still missing.

If this is true, it makes the job of the central banks much harder. Controlling money supply through higher borrowing costs has been the standard approach to controlling inflation for over 40 years. This time, though, monetary policy may be less effective as a gradualist policy. Instead, the central banks may need to raise unemployment by raising rates quickly and significantly to slow inflation, something they have so far been reluctant to do. But that may change.

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