Over the past four years the US Federal Reserve has provided the economy with more than $3 Trillion. With all that money printing the logical conclusion is that we should be having super high inflation. But this is not happening. Our inflation numbers are running about 2% for core inflation (food and energy excluded.) The recent mini crash in gold prices is also confirming low inflation expectations. Gold prices usually rise during periods of high inflation as they did in the late 1970s following the jump in oil prices. All goods and services followed oil higher and set in motion a time of runaway inflation.
Why do we have this seeming contradiction-rapid money printing and low inflation? This puzzle is confounding some of our leading economists. To find answers we must follow the money trail. How do we do this? Let’s look at the factors that affect money. First off, we have the money supply. We use a measure called M2 that includes the money in circulation plus interest bearing savings and time deposits. Second, we look at the velocity of money-how rapid money moves through the economy. This we call V. Then is we put these two variables together we have inflation or P.
When the market crashed in 2008-09 two things happened. The money supply M2 started to shrink. It is estimated the $7 trillion of world wealth vanished. The money that was left has been used to pay off old debts. While this was happening the demand for new money was almost non-existent. Bank lending correspondingly fell off. These two factors created a condition not seen since the Great Depression. You have the money supply shrinking (M2) and the velocity (V) or movement of money throughout the economy falling at the same time. The result has been low inflation (P).
Slowly, over the past four years we are seeing a slight improvement. The pace of foreclosures has slowed, taking some pressure off the housing sector. Unemployment while still too high has come down a bit. Households have been paying down debt and have more disposable income. We are seeing more credit card offers with low introductory rates. The credit card companies have pretty much stopped slashing credit lines.
The one critical factor looming on the horizon is when banks start lending again. When a bank lends you money it creates a multiplier effect. The bank credits your checking account with the amount of the loan giving you the money to spend any way you want. What the bank has done is “created” this new money. And since most likely you will make purchases, the velocity of money (V) speeds up.
To sum up, the danger for high inflation may still be muted but next year if banks loosen the purse strings we could be in for another bout of higher inflation. Inflation usually starts with rising commodity prices. For investors it is wise to keep a watchful eye on commodities. One easy index to follow is the Commodity Research Bureau’s (CRB) index. It tracks prices of major commodity prices.