It turns out, at least over the past 25-year period, that the answer has been “no.” Money and inflation have actually exhibited an inverse relationship (see Figure 2). If one looks at a longer period into the 1960s, the relationship does turn positive, though it remains weak at best. But recent history alone does not
mean that investors should become complacent to the threat of inflation. So let’s dissect the relationship between the expansion of the Fed’s balance sheet, money supply, and its effect on inflation.
We start with a simple equation put forth by the Monetarists, a school of economists focused mainly on the government’s control of the money supply as a primary means of controlling both economic output and price levels. Using a common Monetarist equation, we attempt to explain the relationship between money supply and inflation: MV = PY.
Put simply, this equation states that the money supply (M) multiplied by the number of times each dollar exchanges hands (velocity of money, or V) must equal the prices of goods purchased (P) multiplied by the total purchases in an economy (Y). Manipulating the equation and changing the terms to changes in each variable, we rewrite as ΔP = ΔM - ΔY + ΔV. This states that inflation (represented by ΔP for change in prices) will rise if the supply of money is growing faster than the growth in output, unless this is offset by a decline in the velocity of money.
While many worry that the rapid rise in the Fed’s balance sheet — roughly 135% year-over-year since the start of the crisis — will invariably result in a rapid rise in the money supply in the real economy, this simply hasn’t been the case. Rather, most of the purchases intended to pump money into the real economy have actually sat idle with the Fed as excess reserves (Figure 3). A simple analogy would be the Fed’s printing one trillion dollars in $100 bills, and
Data via the Federal Reserve and the Bureau of Labor Statistics
A Dramatic Decline In The Velocity Of Money
We have seen that money growth itself has been contained. Let’s return to the equation ΔP = ΔM - ΔY + ΔV, in which we stated that price levels would rise (inflation) if the money supply were rising faster than the growth in output unless offset by a decline in the velocity of money. If we assume that the money supply is growing faster than output (albeit much less than many fear) as shown in Figure 4, then why have we not already seen a rapid rise in inflation?
rather than dropping the notes from a helicopter for lucky recipients to spend, the Fed instead buries the cash in a secret location on a distant island. The Fed has created little spendable currency and thus has contained the growth rate of money. In fact, M2, which is a broad measure of money in the real economy, has been rising at roughly 6.1% year-over-year since the onset of the crisis; this is well within non-inflationary historical context and a far cry from the rapid rate of expansion in the Fed’s balance sheet.
