In a previous article, I used the Quantity of Money equation to explain what the Fed had done to rescue the economy from imminent collapse at the onset of the Pandemic. Today I will explain why doing that caused inflation and why that inflation is not unlikely to be transitory unless certain things happen.

By the beginning of 2021, the Fed had increased the money supply from about $4T to nearly $9T. In other words, the Fed had created nearly $5T of money out of thin air, but initially that did not cause inflation. Why not?

Because during the height of the pandemic, money velocity (that denotes business activities) V shrank substantially, so M*V remained stable, not putting much upward pressure on P. 

As the economy gradually reopened, however, V also gradually returned to pre-crisis levels. Now M*V is double what it was. On the other side of the equation, either P or Q (or their product) has to double. 

Why can’t Q double?
As  I wrote before, Q consists of goods, services, and assets that produce goods and services. In America, goods are mostly imported while services are mostly rendered domestically. Let’s put aside assets for now since they can not increase in quantity overnight anyway. Because of the pandemic, many people left the labor market, causing a substantial labor shortage in the service sector. Therefore services can hardly increase, let alone double. Imported goods have indeed increased a bit, but due to the trade war and logistic bottleneck, they can also not increase much, let alone double. This leaves only the total price level, P, to double. 

The doubling of asset prices has already more or less happened: the S&P 500 went from the pandemic panic bottom of 2300 in March of 2020 to the peak of 4800 at the end of 2021. The doubling of the prices of goods and services has just started. The process will continue unless one or more of the following happens: 

Q, the quantity of goods and services, doubles. I’ve just argued it is not happening.
V, business activities, halves. This means accepting a deep recession. It is politically unacceptable. 
M, the money supply, halves. This is what the Fed is trying to partially do. In fact, the Fed has signaled it will cut the total money supply by 30%. That will possibly mitigate inflation over time but will not eliminate it. 

Then there is the element of inflation expectation and the Fed’s credibility. I will write about them in my next article. 

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