The Federal Reserve has been printing money left and right. The dollar has depreciated. Surely 1970s style inflation is around the corner, right? Well, clearly, we have rapidly grown the money supply. This graphic shows that the money supply has grown over time, but the growth rate accelerated during the financial crisis.
Equally important, the balance sheet of the FED has grown, largely through the purchases of mortgage-backed securities.
These two factors, alone, should give pause to anyone paying attention. But, yet, we are not seeing significant inflation. Why? Consider the following equation:
PY = MV
Think of the left side as GDP…or prices times economic output. The changes in the left side determines whether there is inflation (increase) or deflation (decrease). The right side is the money supply (M) multiplied by the velocity of money (V), or the number of times money turns over in the economy. So, if the money supply (M) is rising, shouldn’t we have inflation? Well, consider what is happening to V:
The velocity of money has dropped dramatically. Therefore, the Federal Reserve had to increase the supply of money to offset the drop in velocity to avoid an outright contraction of the economy.
Now, the pickle we are in relates to the balance sheet of the FED. When (if) V begins to rise, we will start to see inflation if the FED does not decrease M. But, given the massive amount of mortgages it holds, they must, at least in part, sell mortgages to draw M down. Sell them too fast and you can crash the mortgage market (again). Sell them too slow, and you risk a rapid rise in inflation.
But, for now, V remains low (and declining). Watch this variable (data available from the Federal Reserve) to get an indication of future movement in inflation and interest rates.