Realamh

Understanding Inflation: Is it transitory or persistence?

Education
FRED:CPIAUCSL   Consumer Price Index for All Urban Consumers: All Items in U.S. City Average
The velocity of money ( M2V ) is the rate at which consumers and businesses spend money and it’s calculated as the ratio of gross domestic product to the country’s money supply.

MV = PY
or
V = PY /M


  • M: Money growth.
  • V: velocity of money (or the rate at which people spend money).
  • P: the general price level or inflation
  • Y: the number of goods and services produced or real GDP

From the first equations we can also derive the following:

delta M + delta V = delta P + delta Q

Delta-M: Change in money growth
Delta-V: Change in the velocity of money
Delta-P: Change in prices
Delta-Y: Change in real GDP

According to Irving Fisher’s theory if the interest rates are fixed and people don’t hold their money, then the velocity of money is a constant. Changing our previous formula to:

delta M = delta P + delta Q
Money growth = real GDP + inflation


Or

delta P = delta M – delta Y
Inflation = real GDP – Money growth


So, if money growth exceeds real GDP, then we would see real inflation . But a fast-growing country would have a faster-growing GDP and the government must print money to prevent deflation in the long run. Since real GDP is also related to the development of economic resources and technologies, it’s considered to be constant short term making the argument that money growth is directly proportional to inflation . Therefore, when a huge amount of money was printed last year, we expected to see some inflation that we are seeing right now.

Now the issue is that the Velocity of money is not constant, and hints about the economic strength and people’s wiliness to spend money. So, if there is a lot of money printed but people are too afraid to spend it then velocity should decline. One reason for people not spending money is the low-interest rates, making bonds less interesting for investors. But not only people did not spend their money, as usual, there were also fewer transactions and sharp decline in GDP due to lockdowns and the fact that some sectors were completely shut down during the pandemic. As you can see on the chart, with a reopening the GDP has been catching up and might exceed the money supply bringing the velocity back to its previous rates or higher.

With the reopening, we also have more people spending their money causing a spike in demands for goods and services in a relatively short period while the economy is taking it's up to meet this demand. Therefore, many investors are considering inflation a threat that may lead to increased interest rates. Although the velocity of money is said to be too variable in the short term and is not a good indicator of inflation , it’s interesting to see its relationship with US Bond 10-year yield.

Now the question is why some economists think inflation is transitory and not persistent?

There are a few reasons:

1. As you may have noticed yesterday the commodities had a huge drop and should continue going down with the reopening reducing business costs and ultimately contributing to lower prices.
2. Employers have been forced to increase wages and that’s a permanent decision because they can’t reduce the wages once they increased them. However, with technological advancements, people are constantly being replaced with machines and robots, which could ultimately reduce the business costs over time.
3. There is more demand than supply because of increased money growth which could lead to inflation . However, with the reopening and by the time the unemployment benefits stop by September, people are forced to get back to work, and GDP would spike up. Since the government is going to stop or reduced the rate of money growth, higher real GDP would cause a relative deflation and bring our current state of inflation back to 2%.

In conclusion, the inflation rate that we are seeing right now should go back to normal within a year or two. That would be a sign for rather a healthy economy making the case for tapering and the dot plot to be skewed toward even higher interest rates for 2023 and 2024.

This is a simplified version of what's going on so please feel free to share your thoughts and analysis in the comment section.

Also, if you are interested to see how bitcoin fits into our current economic cycle , check this out and let me know what you think:

Comment: also Q and Y are the same thing.
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Regards,
Amir H.

Comments

The exact calculation about inflation is not known by many. It helps to know the granular details for how often the word is said. This was featured in Editors' Picks!
100 coins
+9 Reply
@TradingView, please add the M2NS and M2SL series to TV! The FRED:M2 series is expired.
<3
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Nice write up.

I am however sceptical that money grow will slow down long term.
These days, the second the economy gets into trouble, the money printer is turned on with more ease than ever before
There are also diminishing returns of printing more and more money (i.e each dollar printed contributes less and less to GDP growth).
We shall see but I appreciate the write up.
+3 Reply
We are likely headed for deflation not inflation.
+2 Reply
FEDMarkit BigAccount
@BigAccount, inflation initially but then deflation.
+1 Reply
mab79660 BigAccount
@BigAccount, I don't understand I guess. How can we have printed 30% of all US Dollars ever printed in the history of America in one year, and be risking deflation?
Reply
Lots of job openings and employers are finding it difficult to find employees even with 80-120k positions. I suspect employment to also increase in September once the stimulus checks run out.
+1 Reply
@Michael_Harding I hope the government stops printing money like toilet paper. I live in Las Vegas and companies are desperate for employees. Yet, the gov. keeps handing out unemployment checks. This is ludicrous!!!
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The velocity of money is low because there's too much debt in the system sucking exponentially more money into a non-productive black hole. If rates were to ever rise again, the word fundamentals will have to be relearned by the majority of market participants. The Fed keeps printing, we'll have Japanification in western markets, and flat lined GDP growth. Long story short, stagflation is coming. The interest on the national debt ($27 Trillion) is $378 Billion for fiscal 2021. Wait until rates rise...
+1 Reply
Sternbild Hedge_Of_The_World
@Hedge_Of_The_World, When the rates rise what d'you expect to happen?
Reply