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Understanding Inflation and the Pace of the Economy

By August 11, 2023Commentary

Like most people I have assumed that the fake recovery fueled by excessive federal spending will end and there will be a serious recession.  There is a limit to how much economic growth you can buy, and the more you try to buy, the worse the crash becomes.  And there is the little issue of phony statistics being put out, particularly by the Bureau of Labor Statistics.  It is a running joke now regarding how much every month’s numbers will be revised down in succeeding months.  As always I encourage people to believe that you can dig around and find and understand information that gets you closer to the truth.

Two good places to look are at the money supply data and the velocity of money.  I am providing you with a couple of links, but you can google or Bing and find a lot of sources.  According to the monetarist school of thought, led by Milton Freidman, inflation is a monetary phenomenon and money supply can be related to economic growth.  But it appears to me that some of the typical indicators used to signal a recession are warped this time around.  Look at this five year chart of the US M2 money supply.  That is money broadly defined–financial resources that people have access to for spending.   (M2 Supply)

One way to assess the money supply is on a per capita basis or in relation to economic growth.  A neutral policy is probably one in which the money supply grows at the same rate as the economy on a per capita basis.  If it is growing faster than that, you might expect more inflation and perhaps more growth.  If it grows slower, that may signal slower growth or a recession.  So recently, there has been a plateauing and then a reduction in money supply growth; which many, including my friends at Zero Hedge believe heralds a recession.  But I think this time really is different and the chart tells you why.

Observe the trend line pre-epidemic, the spring of 2020.  Look at the enormous spike up in 2020.  That is all the federal dollars that were given our freely and fraudulently stolen.  From about mid-2020 until 2022, very rapid growth continues, also above the pre-epidemic trend.   During 2022 M2 plateaus and there is a slight decline in early 2023, before Bidementia tries a secret round of stimulus to goose the economy before election time.  But M2 grew at over a 35% rate from before the epidemic to now, far faster than either the economy or the population grew.  It is no surprise that people spent a lot and that all that spending in a supply-constrained economy caused inflation.

And that enormous surge in M2 is largely still in place, so the slowdown in growth is far less likely to signal a recession.  There is just a lot more money floating around out there to be spent.  And it also is likely to provide continued support for inflation, which I think will re-accelerate later this year, partly because of interest rate increases, which may cool the economy, but also raise the price of everything.

The second component that can affect the economy and inflation is the velocity of money–how many transactions is it used for or how much of it is spent in a given period of time.  A chart on velocity, along with some good article links, is found at the St. Louis Federal Reserve Bank site.  Interestingly, velocity was declining for several years pre-epidemic.  Not sure if this is due to inadequacies in measuring the money supply, or to the slow growth we experienced in most of those years.  Also no clear to me whether this is nominal or inflation adjusted money.  If it isn’t inflation adjusted, then the same amount of money is actually supporting fewer transactions, due to each transaction costing more.  That could appear to slow velocity, although the total absolute number of dollars being spent may be higher.  (Velocity Chart)

Velocity plunges at the initiation of the epidemic.  People are fearful and hang on to their money and the stupid lockdowns eviscerated spending.  Then the government handouts begin and velocity recovers and really begins to ascend in 2022 and 2023.  It is mystifying to me why velocity had a long decline in the US, over a decade.  I intend to keep studying the issue.   While not back to pre-pandemic levels, the recent increases in velocity may also offset some of the effect of any reduction in the money supply.  It is complicated, but understanding trends in this data and why the trends may exist, can help us figure out what really is happening in the economy.


Join the discussion One Comment

  • Mike M. says:

    “Also no clear to me whether this is nominal or inflation adjusted money.”

    It does not matter. There are dollars in both the numerator (GDP) and denominator (M2) so as long as real or nominal dollars are used for both, the ratio will be the same.

    I too have been puzzled about the long term decline in velocity of money.

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