Again no inflation? Velocity of money and the E-P ratio reexamined

A lot of investors are wondering when exactly can we expect inflation to hit our economies? An economist's answer - only in the long run. 

This bad joke is turning out to be true. Despite the huge, unprecedented (sic!) rise in money supply over the past year, it is unlikely we will experience a rapid increase in inflation over the coming two years. Why is this so? 

Let's start with a fascinating development on the money markets. Velocity of money, that important indicator derived from Fisher's quantitative theory of money (MV=PQ) measuring the circulation of money in the economy (how fast goods are bought and sold), became detached from the real economy approximated by the employment-population (EP) ratio. 

For those new to the blog, I have been particularly fond of tracking these two indicators, and for a very good reason - I find them a realistic portrayal of the situation in the real economy. The velocity of money has, thus far, been a great indicator of economic activity. When it goes down it means that less money is circulating in the economy, less goods and services are being bought and sold, which implies a recession. If it is not recovering, it usually means that consumption is lower and hence the economic recovery will be slower. 

Closely correlated with the velocity of money over the past few decades has been another great indicator of real economic activity - the employment-population (EP) ratio. I consider the EP ratio to be a much better indicator of labor market strength than the unemployment rate. It counts the total amount of people who have a job divided by total population. The unemployment rate only captures people who want to work (those actively looking for a job). It doesn't account for anyone outside the labor force. I used the EP ratio as a signal to track the recovery of the US and EU economies after the previous crisis, given that unemployment data suggested that unemployment was going down, but the EP ratio kept being stubbornly low and stuck at 58% in the US for over four years. This meant that unemployment wasn't going down due to strong job creation but rather as a consequence of many people leaving the labor force (some retiring early, others postponing entry into the labor market). The ratio hadn't started truly recovering until mid-2014 and has been steadily increasing until March 2020. It never got back to the pre-2008 crisis levels of 63%, but since the fundamentals of the US economy changed, this development made sense. 

However, during that entire period of a gradual recovery in the EP ratio, the velocity of money kept declining. For the first time ever these two indicators moved against one another, which is a very strange occurrence. One would think that more people getting jobs would increase spending (which it did), which would, consequentially, increase the circulation of money in the economy - the rate at which goods are exchanged. But it didn't. 

Why? For that we must look to the Fed. Velocity of money is defined as nominal GDP divided by M2 money stock. Money stock has been growing much faster than nominal GDP so velocity obviously went down. Velocity of money reached its first historical low in Q2 2017, at 1.43. Until Q2 2020, of course, when it dropped down to only 1.1 (mind you, this is an indicator that has typically been around 1.8 to 2 throughout the past half century). It has again finally been united on the same trend as the EP ratio, albeit only briefly. The EP ratio started its own V-shaped recovery whereas the velocity of money is still incredibly low, especially for a (supposedly) booming economy. 

What does this all mean? For one thing it explains why we're not witnessing any inflation. 

As I wrote back in 2014, the last time I looked at these relationships: 

"This again does not mean that high velocity will lead to high inflation, but low velocity will surely prevent inflation from occurring. Basically we can say that the decline in the velocity of money has offset the average annual money growth." 

But what happens when employment and consumption pick up again? Will the velocity of money pick up and will this increase inflationary pressures? That depends. Notice that the only reason why velocity of money is low is because the expansion of the monetary supply is greater than nominal GDP growth. In other words, the market growth over the past decade has been driven to a large extent by the Fed's expansionary policies. This was not a standard robust economic recovery. It was a recovery driven artificially by expansionary monetary policy. 

To put it more bluntly, all that money created by the Fed never got translated into the real economy. The biggest beneficiary were the equity markets. What's happening in the second half of 2020 is merely a continuation of a trend from the past decade. Aggressive expansionary monetary policy is driving markets high but because none of this money is going to the real economy in boosting nominal GDP, there is no consequential increase in inflation. 

What about low interest rates? Shouldn't low rates imply easy money? Not at all, according to Milton Friedman:

"Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy. 

After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die."

Low interest rates, according to monetarist theory, typically suggest that inflation will go down. Especially in post-crisis times like these. We already have such a scenario - Japan, with its three-decade-long low interest rates and borderline deflation. Its monetary base expanded to truly unprecedented levels, as did its debt-to-GDP, but there has been no consequential inflationary pressure. Quite the opposite actually. 

Our societies are therefore converging towards a Japanese scenario where interest rates will have to continue to be low (don't expect 3-4% rates at any time over the next decade), monetary expansion will continue, velocity of money will be low, and a large part of nominal GDP growth will be driven artificially. Banks and big companies will continue hoarding cash. This is now turning into pure psychology - as long as there is faith in such a system, growth will continue. This is the new normal.