Recently, an article was published on Seeking Alpha which purported to explain why inflation in the U.S. has remained subdued even in the face of an increase in the M2 money supply. The argument is that the sharp decrease in the velocity of money accounts for the fact that inflation hasn't spiraled out of control even as the Fed has kept two fat fingers glued to the "CTRL" and "P" buttons on the keyboard.
Contrary to the premise of the above cited article (i.e. that "most hawkish commentators have interpreted this as either an error in calculation...or a delayed effect"), virtually everyone who is seriously interested in the issue understands the relationship between the velocity of money and subdued inflation. Indeed, it would take a bout of extraordinary negligence (not to mention amnesia regarding the principles of basic monetary economics) for the majority of hawkish commentators to ignore the following chart which shows that the velocity of the M2 money stock is at its lowest level ever:
Source: St. Louis Fed
Is the sharp decline in the velocity of money a factor? Well, sure it is and virtually everyone knows it. There are however, other factors at play and one of these factors has been virtually ignored by mainstream economists, the media, and the bevy of supposedly savvy market commentators.
Let's start with a slightly more nuanced (although still hopelessly deficient) argument about why money printing won't cause inflation. In a speech delivered in the summer of last year, San Francisco Fed president John Williams argued that interest on excess reserves (IOER) is the primary reason why QE has not stoked inflation. Williams begins by asking a rhetorical question:
"How could the Fed have tripled the monetary base since 2008 without the money stock ballooning, triggering big jumps in spending and inflation?"
So breaking this down, the monetary base comprises circulating coins and paper money, vault cash, and central bank reserves. M2 includes currency in circulation, checking deposits, CDs, savings deposits, and non-institutional money market funds. Textbooks will tell you that when banks have excess reserves, they will be inclined to immediately lend them out. You see, once upon a time, banks made money from lending rather than speculating on CDS indices. So, in the textbook version of the banking system, the more excess reserves banks have, the more they lend and the more they lend, the more deposits are created via the money multiplier. Here's Williams:
"Normally, banks have a strong incentive to put reserves to work by lending them out...If the banking system as a whole found itself with excess reserves, then the system would increase the availability of credit in the economy, drive private-sector borrowing rates lower, and spur economic activity. Precisely this reasoning lies behind the classical monetary theories of multiple deposit creation and the money multiplier, which hold that an increase in the monetary base should lead to a proportional rise in the money stock."
So more reserves should equal more loans which should, by virtue of the money multiplier, increase deposits and ultimately, the money stock. This of course, has not happened. The following chart shows the monetary base and M2 indexed to 100 in 2007:
Source: St. Louis Fed
Clearly, M2 has not kept up with the expansion of the monetary base post-crisis. Now have a look at the M2 multiplier to see why:
Source: Mish's Global Economics
Williams anticipates the next logical question and generously asks it for us:
"But, once the economy improves sufficiently, won't banks start lending more actively, causing the historical money multiplier to reassert itself? And can't the resulting huge increase in the money supply overheat the economy, leading to higher inflation?"
Williams claims the answer is "no." The reason, he says, is because the Fed pays interest on reserve balances. This was not the case prior to 2008. Now, banks are effectively paid not to lend. Banks are now free to treat excess reserves as though they are T-bills -- that is, they are interest bearing assets. This discourages lending (especially when banks are still wary of borrowers' credit worthiness) and causes the multiplier to break down. Incidentally, it is these interest payments that will cause the Fed to swing to a loss in the coming years.
So ultimately there are two components to the argument that hyperinflation will never come. First, the velocity of money has fallen off the charts (literally) in terms of historical data and second, the interest paid on excess reserves has caused a fundamental shift in the relationship between the monetary base and M2.
Taking the second argument first, I would say that anyone who thinks banks will forever be content to collect a miniscule .25% from the Fed for the trouble of parking their excess cash hasn't been to JPMorgan's CIO office lately. Stripping out the cynicism: banks will eventually seek out a greater return on their cash which will restore the multiplier to more normal levels and stoke inflation in the process.
In order to set up the answer to the first argument (about the velocity of money) consider the following quote from the Seeking Alpha piece cited above:
"At some point the economy will improve, consumer confidence will be restored, and people will move from saving to spending. When that happens...the Fed...will lower the money supply to counter the increase in the velocity of money, and inflation will remain moderate." (emphasis mine)
In all likelihood however, the Fed will not be able to stop boosting the money supply. To see why this is the case, we must once again plunge down the shadow banking rabbit hole.
Perhaps the best way to begin is by noting that since December of 2008, the total amount of shadow and traditional banking liabilities hasn't budged -- it has hovered at around $30 trillion for the past four years. This is due to a dramatic deleveraging in the shadow banking sector and a convergence of shadow banking liabilities and traditional banking liabilities.
As I noted in my previous piece on shadow banking (cited above), the contraction of the collateral multiplier (i.e. collateral isn't being repledged or reused as much as it once was) has caused the shadow banking sector to contract by some $6.2 trillion over the past four years alone. Meanwhile, traditional banking liabilities (think deposits at an all time record, etc) have risen. As Zerohedge noted last summer in a fantastic piece on this very subject,
...as of March 31, 2012, the spread between Shadow Banking and traditional financial liabilities has collapsed to just $206 billion, after hitting a record $8.7 trillion in March 2008.
Think about that. That means that the gap between the shadow banking sector and the traditional banking sector closed by $8.5 trillion in just 48 months.
Now consider what this means for inflation and for the Fed's (in)ability to stop printing money. There are no deposits in the shadow banking sector. It creates credit (as much credit in fact, as the traditional banking sector) via the pledging and repledging of collateral. The entire system is based on trust and counterparty risk and as such, there is no actual money (to speak of) that can spill out into the real economy. From Zerohedge:
...since there are no deposits, there is little risk of the "money" contained in the [shadow] banking system furiously vacating and being used to spur purchases of everything from 1,000x P/E/ stocks, to overvalued housing, to just being packed away safely in a mattress. In other words, the Shadow Banking system is circular as the money contained therein is self-contained.(emphasis mine)
In short then, the shadow banking system cannot, by its very nature, spur inflation in the same way credit expansion by money printing can. Excess reserves can escape into the system (despite the allure of a .25% IOER) and from there, the money multiplier takes effect. This is not the case with the depositless shadow banking complex.
Given this, recall that until 2008, this depositless system was creating credit at a far greater pace than the traditional banking system as indicated by the vast disparity between shadow liabilities and traditional banking liabilities. So this was a machine that created vastly more credit money than the traditional banking system but did not pose the same risk of inflation. Consider now, what happens when the balance shifts and the Fed is forced to furiously counter the multi-trillion dollar deleveraging in the shadow banking system by printing money. Suddenly the inflationless credit creation machine is slowing down and the inflation-prone credit creation machine is heating up -- by the trillions on both accounts.
Ultimately then, the more the shadow banking sector contracts, the more offsetting "reserves" the Fed will be forced to print unless it wishes to dash any and all hope that the market's parabolic, phoenix-like rise will continue. As should be abundantly clear from the above however, the more the credit creation burden shifts from the depositless shadow banking sector to the traditional banking sector, the greater will be the risk of runaway inflation. Only once this is understood can one properly begin to talk about the effect of the velocity of money and the money multiplier. They are really secondary concerns in the new world of economics and finance.
Given these dynamics, it would be a mistake for investors to discount the possibility of a sudden and acute rise in prices. Perhaps we should take our cues from the Germans and start bringing home the gold.