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.
"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.
"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."
Post a Comment