Where is inflation?

Have you noticed that over the last four years that many sound financial professionals have been expecting inflation to take off any day now? Yet inflation seems to elude us, almost like an ominous monsoon we can all see on the horizon that has yet to roll in and send everything in its path flying.

Most suggest inflation as a logical result of the Federal Reserve’s 2008 strategy to stabilize the economy by aggressively supporting the secondary market – what we have learned to call “quantitative easing” or QE 1, 2 and 3. In the wake of that strategy, the Fed has since tripled its balance sheet and created trillions of new currency since the beginning of the financial crisis of 2007-08.

These inflation prognosticators base their logic on all of the massive money printing the Fed has created diluting the money supply, therefore leading to higher consumer prices. We certainly follow that logic… so why hasn’t inflation happened (yet)?

The answer is: the velocity of money. You see, for inflation to actually occur, it takes two to tango.

Inflation requires both an increase in the money supply AND velocity of money to make it happen. All of this newly created money doesn’t mean much unless it gets circulated through the economy… Today, much of this printed cash just sits stagnant on bank balance sheets, the fed balance sheet, or is used to de-leverage (pay down debts).

Here is an example: I take the wife out to dinner and we tip the waitress $20. That waitress then uses that $20 for a cab ride home. Then the cab driver takes that $20 and uses it to put gas in his car. That same $20 was circulated in three different transactions. That’s velocity of money. Now compare that to this example: I take the original $20 and use it to pay down my credit card balance… that’s it. The money only gets used once.

In the first example I felt confident that things were going well and decided to spend my money, and it ultimately was used over and over and over.

The Fed desperately wants some inflation and they have explicitly targeted 2 – 2.5% per year. So far they’re printing $1 trillion per year to get it, but its not happening. As we hope you can now see, the Fed can print as much money as they want, but they have no control over consumer psychology or how people spend their money. And until there is “consumer confidence” we will not have the velocity of money.

Categorized in: Blog

This post was written by Conscient Capital