Inflation Is Always & Everywhere a Velocity Phenomenon

As CPI in the US slowed to 6.5% this month on a year over year basis, inflation is now proving much more (dare I say) transitory than many expected. All things being equal, inflation looks set to continue its slide this year meaning the entire period of rising prices since mid 2021 will have lasted just over 18 months. So much for the hyperinflation predicted by some analysts in the face of 'reckless' government spending and money printing. 

​As I’ll discuss in this article there are many factors that influence inflation, and not all relate to money supply or oil prices. One of these factors includes the velocity of money, or the speed at which transactions take place per unit of time, which in my view has largely been neglected from discourse. Instead, the obsession with monetary and fiscal policy has driven the inflation narrative in recent years which explains, believe it or not, only a small part of the story. 
 
Imagine a simplified economy consisting of 10 people, 1 shop and the total available spend in the economy being €50 which neither increases or decreases. What scenario would be more inflationary, 1 person spending €10 in the shop every day for 5 days or 10 people spending €5 in the shop in 1 day?
 
Let’s return to the velocity topic later, and in the meantime look at how money is created in the economy. This will give us a better understanding of the mechanics of how money works and the channels through which it flows that potentially cause or do not cause inflation along with velocity. There are 2 main sources of money creation in a modern economy for the government, quantitative easing (QE) and borrowing. 
 
QE is the process of a central bank printing money to buy government bonds. The central banks buys these bonds from commercial banks and pension funds, usually in exchange for other financial assets and collateral. Pension funds benefit from rising bond prices and commercial banks use the proceeds from the bonds to lend to other banks in the financial system. As the supply of new loans increases, the interest rate banks charge one another falls. Lower interest rates boost equities and investment banks make profit. These profits flow back into financial markets inflating commodity prices, stocks, bonds and so on.
 
The point here is that QE mainly affects asset prices because the money printed from the central bank stays largely within the financial system. The years following the financial crisis is the perfect case study. Despite large monetary and fiscal stimulus, inflation in the US remained unchanged while stock markets boomed. Despite his best efforts, President Obama’s “helicopter money” had little effect on consumer demand as many consumers chose to save their cash instead of spending it. For large periods of the recovery, inflation hovered between 1%- 2%. 
 
Japan, which invented QE in the 1990s in response to the Asian banking crisis, has been stuck in a deflationary trap for over 30 years despite its central bank pumping huge amounts of QE into the economy during that period. Ageing demographics, a lower propensity to consume and a higher savings rate (which is included in M2 money supply) have suppressed wages in Japan for decades. With a debt to GDP level of over 200%, huge government spending in Japan has failed to create inflation.

The link between money supply and inflation is thus no longer as straightforward as we once believed. Milton Friedman’s famous phrase in 1963 that “inflation is always and everywhere a monetary phenomenon” now appears somewhat ambiguous. Interestingly, in recent months Japan’s inflation rate finally rose above 2% for the first time since 1991. 
 
The latest burst of inflation worldwide, therefore, stems not from the quantity of money circulating in the economy but from the nature of how and when money is spent. Think about the early parts of the first lockdown where a large demand shock to durable goods sent prices soaring. Home appliances, garden tools, gym equipment, barbecues etc. A second demand shock took place to non-durable goods and the services sector when economies re-opened. Prices at hotels, restaurants, cafes and travel-related services all rose sharply. For much of the pandemic, supply shortages and tight labour markets struggled to match the sheer volume and speed of transactions that took place simultaneously that drove prices higher and caused the initial spike in the CPI.
 
Although QE allowed governments around the world to borrow and spend in enormous amounts, wages in Ireland during the pandemic largely remained unchanged. According to the Central Statistics Office, the median annual disposable income in Ireland in 2019 was €42,956. In 2020, it had risen to €43,092, an increase of just €136. So despite the largest fiscal stimulus programme in the state's history, the effects on incomes were almost negligible. And yet inflation still took off.
 
It’s important to note, too, that some of the world’s poorest countries experienced inflation during the same period despite receiving little or no government supports. By the middle of 2021, the inflation rate in Afghanistan for example hit 5%, roughly the same rate as most of the developed countries. Where the US had spent 15% as a share of its GDP on fiscal supports in 2020, the Afghan government had spent just 2.2% as a share of its GDP. The AFN/USD exchange rate broadly remained stable during this time too, so inflation in Afghanistan could not be explained by a devaluation of its currency.
 
Like millions of other consumers around the world, Afghanis spent whatever small amounts they had in short, quick bursts which caused domestic prices to spike. Like in many of the richer economies, inflation in Afghanistan had less to do with an increase in the level of money people held in their pockets but more to do with the speed at which their money was exchanged from person to person. In normal times the velocity of money would be dispersed more evenly over time thus preventing prices from rising so rapidly.

​With this in mind let's return to the imaginary economy mentioned at beginning of the article. Would 1 person spending €50 in the same shop over a period of 5 days (€10 per day) be as inflationary as 10 people spending €5 in the same shop in just 1 day? Very unlikely. Inflation would occur from more people spending on the same day despite the amount of money being spent being equal in both scenarios. Hence, inflation is not always the result of an increasing or decreasing money supply.
 
To be fair, this is probably why central banks assumed inflation would be transitory at the beginning of the pandemic. Even during peak inflation late last year the argument that inflation was the result of longer term structural changes in the economy was fairly unconvincing. Tighter labour markets could push wages higher; but unlikely high enough to cause persistently high inflation. China’s re-opening might cause a spike in commodity prices and the war in Ukraine may also effect the price of oil and gas. But these are all one-off events that will likely affect prices on a temporary basis only. 
 
Indeed the consensus in financial markets now is that central banks could achieve their soft-landing after all, despite all the negative commentary over the past 12 months. Stock markets rallied on the back of the Fed’s announcement on Wednesday that it would raise rates by just 0.25% in March. The S&P is up 8% since last year and the Nasdaq is technically in a bull market climbing 20%. Even Bitcoin jumped 40%. Giddy markets are the last thing central banks want right now, however, and in my view could prove costly to investors. Friday’s jobs report, for example, that showed the unemployment rate in the US falling as low as 3.4% could give more reason to the Fed to hold interest rates higher for longer. So while a soft landing is possible, it’s also very unlikely which history reveals. Since the 1950’s for instance, the US economy has entered a recession within 2 years every time inflation exceeded 4% and unemployment fell below 5%. In all cases, tighter monetary conditions were to blame for falling GDP.
 
The concern over the next year or two, therefore, will be the effects of higher interest rates on the economy. Because monetary policy acts with a lag we might only start to feel last year's rate hikes early this year and this year's rate hikes 6 months from now. It’s unlikely too, even in the case of falling inflation, that central banks will suddenly and dramatically cut interest rates. Barring another crisis, the days of interest rates at the zero lower bound are likely over for a very long time.
 
Finally, to bear in mind that banks will be in no rush to pass on rate cuts to customers when rates do finally fall. In 2002, for instance, AIB passed on 0.25% of the ECB’s 0.5% cut 12 months later. And in 2012, AIB increased interest rates even as the ECB was cutting its main deposit rate. Only market forces determine the destination of bank rates, therefore, and in Ireland with the exiting of KBC and Ulster bank, the market has never been less competitive. Irish customers can thus expect elevated interest rates for quite some time and unfortunately despite declining CPI, more pain lies ahead.
 
Should economic conditions worsen the government will at least know that generous fiscal policies that support the economy are unlikely to cause inflation. Inflation is, after all, always and everywhere a velocity phenomenon.