Price Inflation, Monetary Base, and Velocity

This topic is discussed frequently on this blog, but it is a very important one.  It affects the economy in huge ways and it therefore affects our investments.  In most transactions that take place (which is billions of transactions in a day), money is on one side of them.  That is why money is such an important topic.

After the fall of 2008, the federal government, hand in hand with the Federal Reserve, bailed out failing businesses, particularly the banks.  The Fed more than doubled the adjusted monetary base, which is the money supply that is directly controlled by the Fed.  This doubling of the monetary base was unprecedented as nothing anywhere close to this had occurred since the Fed was created in 1913.  Many Austrian free market economists thought this would lead directly to price inflation.

However, another historic thing happened in all of this.  The banks are required to keep a certain percentage of money in reserve that is on deposit.  In the U.S., it is currently around 10%.  If someone deposits $100 into a bank, the bank will typically lend out $90 and keep just $10 in reserve.  The banks are counting on the fact that most depositors will show up at the same time to withdraw their money.  If this did happen (a run on a bank), then the FDIC would reimburse the depositors.  This protects the banks from runs and it allows riskier behavior for the banks.  But 2 years ago, the banks dramatically increased their excess reserves voluntarily.  The money that was created by the Fed did not flood the system.  Banks did not lend this new money.  This kept the fractional reserve process from taking place.

This is one of the major reasons that we have not seen massive price inflation.  There is one other reason too and that is velocity.  Velocity is the speed at which money changes hands.  After the fall of 2008, people became more conservative with their money.  As people were losing their jobs, housing prices were going down, stocks were going down, and people were becoming more concerned with the future, habits changed.  People did not spend as much.  Instead they paid down credit card debt and other debts.  They saved more money in their checking and savings accounts, even if the interest rate was really low.  The demand to hold cash went up.  In a recession, cash is king.  This means that money changes hands less frequently.  This has the effect of keeping prices down.  There are less people bidding prices up.  It has the equivalent effect of a deflation of the money supply.

This is why we have not seen massive price inflation.  While the CPI is certainly questionable, there is no doubt that the rate of increase has been low.  Prices also vary depending on what it is.  Housing prices have gone down lately while gold prices have gone up.  Food prices are going up, but certainly not as much as they could.

This is an important subject that should be monitored constantly.  Keep an eye on the monetary base and the excess reserves held by banks.  But it's also important to realize that velocity is a huge factor and it could change at any time.  It is almost impossible to measure velocity, but sometimes you can get a sense just by talking to people and listening to what is happening in the world around you.  When people start buying things because they expect the prices to go up later, then we should expect prices to go up even higher as velocity increases.