Where’s the Inflation?

Intuitively, high money growth and low inflation over the long term should not be simultaneously possible; for if they were, we would face a breakdown of the classical dichotomy between nominal and real economic variables. In other words, if the two items could be achieved at the same time, the Federal Reserve could continue to boost aggregate demand by dropping cash from helicopters while escaping any inflationary repercussions (menu and shoeleather costs, confusion about prices, an arbitrary redistribution of real wealth between lenders and borrowers). More crucially, such a possibility would enable consistent increases in real wealth, as consumers and investors simply received more money without seeing the concomitant decrease in the value of a single dollar required to keep total purchasing power constant in the long term.

Yet to the author, this precise phenomenon appeared to be happening in recent memory: toward the end of 2008, the Fed more than doubled the monetary base to about $1.7 trillion. However, empirical research and official reports continue to project expected inflation at around 2%, unremarkable by historical standards and certainly nowhere above the average rate.  But something’s gotta give, right?

As it turns out, the money growth-inflation link arises from the economic identity M*V = P*Y. In other words, the number of dollars in the economy (M for money supply) multiplied by the number of times each dollar has been used in transaction (V for velocity) must naturally equal the nominal gross domestic product, or price (P) level times real output (Y). Clearly, holding real variables V and Y constant forces price level eventually to rise to match any increases in money supply, and indeed the assumption of fixed money velocity is not uncommon in the literature. So five years later, where’s the inflation?

In their latest quarterly review, two prominent fund managers have proposed an incisive answer consisting of two parts. First, they argue, money supply has increased, but not to the full extent that the Fed’s multiple rounds of quantitative easing might seem to suggest. Specifically, increases in the monetary base have not translated to a great increase in M2, a broader classification of money in the economy which more accurately reflects funds available to consumers and investors. This has arisen from a precipitous fall (from 9.0 in late 2007 to 3.6 as of March 2013) in the money multiplier, a constant by which the “high-powered money” in the monetary base is multiplied to determine M2. Reasons for such a decrease might include higher banking excess reserves or less depository activity by households, but the result is the same: a much-mitigated rise in M in our formula, leading to a tamped rise in price levels.

In addition, the second input on the left, money velocity, has also seen record lows: V is at the lowest it has been in over half a century. The aforementioned authors of the quarterly review propose that this decrease has been driven largely by lowered acquisition of revenue-productive debt; that is, investors have been less able to leverage their borrowing into income streams. As such, transaction frequency has fallen. The left side of our equation therefore increases by far less than originally expected, and therefore, rises in price level have been unremarkable. So while we have seen a very limited impact from the deleterious effects of inflation, this is only because we have also witnessed slow money growth and a fall in rate of money turnover. The classical dichotomy is as real as ever.

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