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Wednesday, April 8, 2009

The Velocity of Money and Upcoming Hyperinflation

The numbers are absolutely staggering. First, there was the 787 billion dollars stimulus. Then, there was the $400 billion plus omnibus spending bill, and now we are working on a budget north of $3.5 trillion. Furthermore, the Fed has announced that they will buy back more than a trillion dollars worth of Fannie/Treasury bonds. The federal government is pumping money into the system at an alarming rate. So, why haven't we seen the the ugly head of inflation yet? The answer lies in the economic term, the velocity of money.

The velocity of money is the average frequency with which a unit of money is spent in a specific period of time. Velocity associates the amount of economic activity associated with a given money supply. When the period is understood, the velocity may be present as a pure number; otherwise it should be given as a pure number over time. In the equation of exchange, velocity of money is one of the key variables determining inflation.

The velocity of money measures how quickly each given dollar filters its way through the system. Right now, everyone is scared. As such, any dollars they get they put away rather than spend. As such, the velocity of money is very low. That said, there is plenty of money in the system but that money continues to be on the sidelines and not being spent as quickly. This will continue as long as the economy is weak and people are afraid. So, what will happen when we begin to recover and people feel better about the economy?

Dick Morris described it well.

Think of a parking garage filled with cars. The cars’ owners leave them in the garage, because it’s a bad day with rain and snow and conditions aren’t suitable for driving. Similarly, banks and consumers leave their money in the vault at the Fed or in their bank accounts or under the mattress.

When conditions improve, though, all those metaphorical cars will suddenly be taken out for a drive. All at once. And a traffic jam of monumental proportion will ensue.

When everybody starts spending the money they’re now leaving in vaults and mattresses, way too much money will be chasing way too few goods and services. Double-digit inflation will return to America.

You could even think of it as this analogy. Think about what happens when someone performs a neutral drop. They set the gear to neutral and hit the gas, and hit it very, very, very, hard. That's what both fed action and government stimulus have done. We can't see the effects yet because we are still in neutral, with velocity of money being very low. So, what will happen when we finally shift to drive? Well of course, the car would not only take off but take off out of control. That's what will happen as soon as the economy recovers and people start spending. Once the velocity of money becomes relatively normal or even aggressive, the full inflationary effects will be seen. They will be staggering and at that time we will begin to fully appreciate the full inflationary effects of all this monetary and fiscal stimulus.


Anonymous said...

Mike, what would you consider hyperinflation? Like what CPI percentage?

Second, is it possible the Fed can simply reduce the monetary supply once the recession has passed?

mike volpe said...

Let me take the second first. Of course, the Fed can reduce the money supply. Here is the rub. We don't go from recession to recovery overnight. Our economy begins to recover. Now, at that point is when the Fed would begin worrying about inflation. If they were to then tighten the money supply, then we would create a new recession.

We may approach 10% unemployment before we begin recovering. So as we recover we will get to 8,7,6, and 5. Well, if the Fed then begins tightening, then the growth gets stunted. So sure the Fed can head off the upcoming inflation but only if they want to put us back into a recession.

I think anything over 5% CPI is hyperinflation. Anything over 3% inflation is worrisome and you go from there.

Remember, inflation is nothing more than a tax especially on all those that are poor and middle class. If prices go up, that means less money in your pocket.

Anonymous said...

While it is true that inflation is like a tax in that the money in your pocket is worth less since there's more money and the same amount of goods to buy, but since when has the average American have money in their pocket?

Savings rates in this country have been abysmal for quite some time and are only beginning to recover. If anything, inflation could be beneficial by making American's debts cheaper since you can pay it off with cheaper money. Granted, once the economy starts to recover there will be a mad dash among global central banks as to who can raise their interest rates faster to prevent prices from going totally out of control, but for the time being this could just be crazy enough to work.

mike volpe said...

What kind of ridiculous tortured logic is that? First savings is only one stat. People will have to spend more on normal everyday things meaning they will have less to spend on normal everyday things.

Inflation isn't going to make it easier to pay back debt. It will make it harder. Credit will be more expensive. Your ignorant analysis won't change reality. Hyper inflation is nothing but a serious nightmare.

Bill said...

Any idea what the velocity of money in Zimbabwe is? Or what it was in Germany in the 1920's? I recently read the sum of 20 million German marks, a considerable sum, dropped in three years to the value of a postage stamp. The speed of the decline in money in Germany was just breathtaking and underscores the rapidity with which this can occur. said...

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