Rising Monetary Velocity Continues to Frustrate the Fed

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Another inflation update from the Cautious Economics Correspondent for Economic Affairs and Other Egghead Stuff

“From Q1 to Q4 velocity increased from 1.14 to 1.226 or up 7.5% which, when annualized, translates to an even worse yearly inflation rate of 10.1%.”

-CO Economics Correspondent
 February, 2023

Well Cautious Rockers the latest M2 velocity numbers are out, confirming the Fed’s policy efforts continue to be frustrated by the higher pace of spending.

In the last four quarters M2 velocity has risen from 1.145 to 1.259 or +10%—meaning if the Fed kept the money supply perfectly flat and GDP was breakeven prices would still rise by 10% a year.

As a reminder the formula for calculating inflation is p = mv/y where p = the price level, m = money supply, v = monetary velocity, and y = nominal dollar value of all goods and services purchased or GDP.

This is why, despite a Fed contraction of the money supply that is unprecedented going back to the 1930’s, inflation stubbornly persists.

(See chart: M2 in red is falling while velocity in blue approaches its highest level in the last half-century)

This sticky inflation, as the press calls it, is being caused by what Fed officials have fretted over for a year now: inflation expectations. As U.S. consumers and businesses expect more inflation in the future they shift their purchases forward to spend their money now before it loses any more value.

Since rising velocity itself can spur further price increases, “inflation expectations” can create a vicious cycle where Americans spend faster, their spending acceleration forces prices up faster, Americans adjust again by spending even faster, and on and on.

The last time inflation expectations generated this level of price pressure was the stagflation era of the 1970’s, and it took a huge dose of Paul Volcker’s 20% interest rates and a painful recession to finally end it.

The Economics Correspondent believes the Fed will have to continue to crack down hard on the money supply to stamp out the velocity problem—although he still doesn’t think the resulting recession will be as bad as 1981-1982 (peak 11% unemployment) *unless*  the Fed creates a major financial crisis along the way.

But it will probably be bad enough.