Could Inflation Actually Increase?

by: Ronald Surz

Summary

Experts see inflation persisting into the future at its current level of about 2.5%.

Quantitative easing (QE) is about to be unwound, allowing interest rates to increase.

The prospect of increasing interest will stimulate borrowing, increasing inflation.

I attended a conference last week where one session was on inflation. The presenters were certain that inflation in the foreseeable future would be 2.5%. Why? Because that's what it's been and there's nothing that will change that.

A monetarist would disagree. There are several things that can change inflation. Let's look at the one factor that I believe will increase inflation. The monetarist formula for the macroeconomic drivers of inflation is:

PT = MV

where P = price level (inflation) T = Transactions, M = money supply, V = Velocity

Rearranging terms, P = V(M/T). In other words, inflation will increase if V = Velocity increases, and an "X" percent increase in velocity will result in an "X" percent increase in inflation.

Many have wondered why inflation hasn't increased with the increase in the M = money supply. Under quantitative easing (QE), bank reserves have increased 9-fold, from $500 billion to $4.5 trillion. Yet inflation hasn't increased because V = velocity has been low since not much of the $4.5 trillion has been lent out. The demand for low interest loans has mainly been driven by stock repurchases.

The Fed recently announced that it has ended QE, and the next step will be unwinding it, which will increase interest rates. Also, the Fed increased interest rates a quarter point to 1% on March 15. QE interest rate manipulation is being unwound.

Interest rates are going up, and this should increase velocity as anyone who is on the fence about borrowing money should do so soon, before the increases. Increased velocity will increase inflation. A doubling of velocity will cause 100% inflation. Still think 2.5% inflation will last forever?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.