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I previously wrote an article on what the latest GDP report says about gold prices. My conclusion was that unless it is a one time glitch, lower GDP growth will be bearish for gold prices. This would be the case even in the face of a sharp increase in money supply, as the velocity of money has kept dropping. It became amply clear from the comments on the article that it was not apparent to the readers how money velocity drops negates increase in money supply, and hence results in the low inflation environment that we are in right now, and how lower GDP growth will in turn make this situation worse.

I am therefore writing a follow up article explaining how money supply, velocity of money, and price inflation are all linked, using the standard Quantity Theory of Money. Hopefully this article will make it clearer why despite a large infusion of money into the US system by the Feds, inflation has been low.

First, what is the Quantity Theory of Money?

In its modern form, the quantity theory builds upon the following definitional relationship.

M\cdot V_T =\sum_{i} (p_i\cdot q_i)=\mathbf{p}^\mathrm{T}\mathbf{q}

Lots of jargon there, so let's first explain the left hand side of the equation with an idealized example. We have two terms on the left hand side, M, which is the money supply, and V, which is the velocity of money.

M is simple to understand - it is the aggregate money supply in the economy held by all the actors who are engaging in buying and selling transactions. But what is V? In the simplest terms, velocity of money is the ratio between total monetary transaction to the total monetary base.

Let's say there is a closed economy with a fisherman, a tailor, and a doctor. Let's say the total monetary base is $60, with each person starting with $20. The fisherman sells $20 of fish to the doctor, and buys $20 worth of clothing from the tailor. The tailor in turn gets his annual checkup done at the doctor, paying $20. So, everyone ends with the same $20 in the end. The total transaction of $60, and the total monetary base is also $60, so the velocity of money in this case is 1.

Let's say now the doctor buys clothing from the tailor next for $20, the tailor uses that $20 to buy fish, and the fisherman gets his annual checkup for $20 in turn. Now, there has been another $60 in transactions, even though the total monetary base is still fixed at $60. Now total transactions is $60+$60=$120, and velocity of money is 2.

Let's now explain the right hand side of the equation. P is the price of goods and services, and Q is the quantity of goods and services consumed. Let's say the price of fish is $20/fish, the price of clothing is $20/shirt, and the price of medical checkup is $20/visit. Then, in both the round trip transactions, one shirt, one fish, and one medical checkup exchanged hands. Putting in all together.

$60 (NYSE:M) * 2 (NYSE:V) = $20 (NYSE:P) * 2 (Q, shirts) + $20 (P) * 2 (Q, fishes) + $20 (P) * 2 (Q, visits)

This is the basics of modern monetary economics.

How can this model be used to predict price inflation? Imagine that the total monetary base increases to $600 instead of $60. Imagine also that the velocity of money remains unchanged at 2. Finally, imagine that the quantity of goods and services consumed remain unchanged at 2 fishes, 2 shirts, and 2 medical checkups.

Then, for the above equation to hold, the price of a fish, a shirt, and a medical visit has to go up to $200. In other words, there will be 1000% price inflation from 1000% increase in the money supply, ceteris paribus. This is what most people are afraid of. The Federal Reserve has sharply increased the money supply in the country, so according to the Quantity Theory of Money, we should see hyperinflation any time now.

However, inflation has been low. Most hawkish commentators have interpreted this as either an error in calculation (inadvertent or deliberate) or a delayed effect. What they have been missing, however, is that the Quantity Theory of Money doesn't work in a vacuum. When M changes, V and Q do not always remain constant as in the above stylized example. They often change with M, thus putting little to no pressure on P. That's what has happened in the USA.

Let's see this with real numbers. Over the past 5 years, M2 Money Supply (M) has grown 36.4%. At the same time, M2 Velocity (V) has dropped 18.7%. Hence, the product of the two (M*V, or the left hand side of our equation) has only grown by 10.8% over the past 5 years, or ~2% on average every year.

Velocity of M2 Money Stock in the US Chart

What has price inflation been in the past 5 years? It has fluctuated between 5% to -2%, and on average has been ~2%/year, exactly what the Quantity Theory of Money would have predicted.

US Inflation Rate Chart

This is why inflation has been low in the USA despite major monetary injection by the Fed. It has to do with velocity of money. So, why has velocity of money dropped? Again, let's go back to our idealized example.

Remember those three guys with $20 each? Let's say the economy becomes really sluggish, and these guys start to get very worried about their jobs. In all likelihood they will start to spend less and save more. Let's say they save $19 of the $20, and spend only $1 in each round trip transaction. Then each round trip only yields $3, and 7 transactions are needed to get the velocity of money to above 1. This is what has been going on in the USA. When people are worried about their jobs, they save more and spend less, hence the velocity of money drops. As the chart below shows, US consumers have been paying down debt instead of increasing it. Hence, they are moving spending dollars into savings dollars, which explains the drop in the velocity of money.

(click to enlarge)

In summary, inflation has very little to do with the money supply by itself, which is why we have limited inflation in the USA. At some point the economy will improve, consumer confidence will be restored, and people will move from saving to spending. When that happens, the velocity of money will revert to historical average, and a 36% money supply growth over 5 years would lead to 6-7% inflation which will be extremely negative for the US economy. This is what people are worried about. However, the Feds at that point will lower the money supply to counter the increase in the velocity of money, and inflation will remain moderate. At least, that's the plan of the Fed.

So, hyperinflation in the USA remains and will likely remain a myth.

What does this mean for gold prices? As I said in my earlier article, gold, being a commodity, can have a price rise from two different stimuli. One, there could be inflation, when gold prices would rise with all other commodities. This as explained above is not the case. Two, there could be increased demand for gold over and above supply increases. However, the Government of India (the world's largest gold importer) has now pledged not only to keep increasing import duties to curb gold demand, but to even move outright into import quotas if import duties are not enough to lower imports.

Given the above, at best we will see a sideways market in the price of gold in 2013, and at worst, this will be the year when gold prices start the inexorable drop. What does this mean for your investment thesis for the rest of 2013, dear reader? Well, my projection for gold prices (NYSEARCA:GLD) in 2013 remains unchanged, that shorting gold -- especially via the miners (GDX, DUST, NUGT) -- remains the play for 2013. For more details, please check out my other article titled "How Best To Short Gold - Miners Or Metal?"

In the meantime, I have initiated a position in DUST. I think the miners are really setting up to be perma shorts with falling gold prices and rising mining costs. I am up on this position by about 1%, and I expect this to be a profitable position exceeding 20% returns. Of course, nothing is a guarantee, but the Government of India position gives me a good reason to believe that I will make money on this.

Disclaimer: This is not meant as investment advice. I do not have a crystal ball. I only have opinions, free at that. Before investing in any of the above-mentioned securities, investors should do their own research, consult their financial advisors, and make their own choices.

Disclosure: I am long DUST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Why Hyperinflation Is A Myth (And What It Means For Gold Prices)