Inflation Rate Remains Tame But For How Long?
Posted April 19, 2011on:
[Adapted from my Morningstar contribution] A year ago this month, after a trip to China I wrote ominously about inflation hitting the US economy like a tsunami.
My opinion was based on two observations:
- China’s labor costs were galloping at a 20% to 30% clip per year, and so much of what we consume is produced in China now.
- The Fed was printing money like crazy.
So far I have been wrong. The February 2011 inflation rate was 2.11%; though a slight uptick from 1.63% in January, it was by no mean a tsunami. Recently, Fed Chairman Ben Bernanke testified before the Senate Banking Committee that the Fed projects an inflation rate of less than 2% for the next 3 years.
This shows yet again nobody can predict the future, “me no exception” (Chinglish used here). But how did I get it so wrong
It turns out that the overall price level of an economy must conform to the equation of exchange, that is:
M*V = P*Q
Where M is the total money supply, V is the money velocity or the speed at which money changes hands in the economy, P is the overall price level, and Q is the gross domestic product. So
P = M*V/Q.
Q did not change much, while M has increased a lot, so the wild card is V, money velocity.
Four month ago, my wife and I got a fabulous opportunity to invest in a townhouse that was selling at half the price of the previous transaction. Despite the fact that my wife’s credit score is over 800, and mine approaches 800, the bank make us jump though hoop after hoop before lending us a measly $170k. Our credit scores are probably in the top 1%; if we have to do gymnastics to get a small loan, just imagine how hard it is for most people. My point: money is NOT moving.
Since Q only drops a bit, M increases, but V decreases by the same magnitude, P will not move. That’s why inflation rate remains tame so far.
As the recovery picks up speed, V will increase. The Fed will need to “mop up the excess liquidity,” that is decreasing M. If this is done too quickly, it could choke off the recovery; if it is done too late, it could create inflation. The Fed needs to time it just right. Do you have confidence?