Sunday, December 20, 2015

Expect Surprising Inflation

The velocity of money is a function of interest rates and inflation rates.   As interest rates go up, the velocity of money will go up.  Originally the Fed claimed they had an exit strategy to reduce the money supply and prevent inflation.   However, they no longer seem to have a strategy for reducing the money supply.   The money supply is still going up, not down.  With an increasing velocity of money and increasing money supply, the equation of exchange predicts inflation will go up.    Since inflation also increases the velocity of money, and so further pushes up inflation, the risk of "run-away-inflation" is real.   Since few other people expect this, most people will be surprised.  Now that interest rates have started going up, we should expect surprising inflation.

At least that is what my theory predicts.   It will be interesting to watch the experiment unfold and the results come in.

7 comments:

  1. I added another interesting graph at the end of a previous post: http://howfiatdies.blogspot.com/2015/09/punchbowl-removal-difficulties.html

    Shows Fed funds rate vs velocity of money. I used base money less excess reserves as "money" and used GNP to calculate velocity.

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  2. Seeking Alpha picked up this post: http://seekingalpha.com/article/3767446-expect-surprising-inflation?isDirectRoadblock=false&app=1&uprof=82

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  3. One possible definition of cash includes as a necessary component a nominal rate of return equal to zero. You could also define money as cash.

    If that's the case, then money/cash would not include any reserves now (nor for the foreseeable future) since they pay a nominal non-zero interest rate. I predict they will continue to pay a non-zero nominal rate (equal to the Fed funds target upper bound rate) as long as excess reserves exist. Indeed, it seems the Fed has opted not to unwind their balance sheet before raising rates. I predict they will continue to do this, and future rate increases will necessarily be matched by equal IOR rate increases.

    Eventually excess reserves may disappear. One mechanism is that maturing Treasuries held by the Fed may not all be replaced with newly purchased Treasuries. Unwinding by this method may take some time. I don't see the Fed being in a hurry to unwind. However, when eventually excess reserves are gone, they are finally free to lower IOR rates below the Fed funds rate, perhaps all the way to zero.

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    1. I see that in an update on a previous post you consider that because excess reserves pay interest, you don't include them as money. However, reserves in general pay interest (including that portion of vault cash deemed to be 'reserves') thus it's not just excess reserves, but any reserves that should be eliminated from the money supply total, no?

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    2. That is a good point Tom. I made another graph using reserves instead of excess reserves. I think it does look even a bit better.

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  4. The graph on http://www.philipji.com/item/2015-12-05/the-fed-is-set-to-squeeze-during-a-monetary-contraction shows that the growth rate of Corrected Money Supply (my measure) has been falling since the start of 2014. The fall in commodity and stock prices is a reflection of this contraction. My prediction is that even if the Fed does not raise rates again this year, there will be a massive crash in one or more asset markets before the end of this year. I do not think that anything short of another QE will be able to prevent the crash.

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    1. Hi Philip. You used to comment on my old blog, right? And you've commented here before. And on pragcap as "phil" back when that had a comments section. Or am I thinking of the wrong guy?

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