QE and Inflation

A great amount of money is being created by the central banks, that we already know. The Fed, the Bank of Japan and the European central bank are monetizing quite a lot of public and private debt; in the case of the Fed, we’re talking about $85 Billion a month, a sizable amount. Nevertheless, we’re not witnessing, for now, any real increase in prices, even though we are paying more for food and energy, a fact more or less disguised in official statistics. But one thing is clear, we’re not seeing a strong inflation.

The Austrian school economist might be put off balance, knowing that any excess money creation leads to higher prices. Sure, but first, higher prices start with commodities (asset inflation), and then they move on to the grocery cart, following a five-year pattern of 5% a year for food and energy.

But, foremost, one has to take into account another element : money velocity. The economist Irving Fisher (1867-1947) had put that into evidence. Because, if the amount of money in circulation rises, but it gets around at a slower rate, both effects nullify, and there is no impact on the prices. And, precisely, this velocity hasn’t stopped slowing down since the 2008 crisis.

The slowdown in growth, as noted in the last few quarters in the U.S. and Europe, contributes to the diminishing money velocity. Central banks are printing like crazy but the money isn’t moving around : lending hasn’t picked up because the economic outlook is bleak, and we only see speculation on commodities, as we said, and on the stock market.
But should we feel satisfied that these two effects nullify themselves and are not bringing runaway inflation? Of course not, because this balance is fragile : money velocity is very sensitive to psychological factors.

Let’s take the most common example, that of a wage earner. In general, he gets his paycheck every month, and he makes his groceries once a week. But if he realizes that the prices are going up within a month, his natural reflex will be to do all of his groceries at once, as soon as his paycheck will be available in his account. And, if millions of people start doing the same thing, then it is easily understood how money velocity explodes. That is the moment the country faces hyperinflation, because people are running to spend (get rid of) their money, it’s an « escape from currencies », denominations are askew, and those who own stocks are waiting for prices to go up still a bit more... and scarcities and black markets proliferate... The result : the economy collapses, unemployment soars, and savers are ruined. A single black swan event or any irrational fear might trigger the shift from inflation to a price explosion and, once it starts, it’s already too late.

What could trigger such a move? Hard to say. When will it happen? Impossible to predict. But, the more « sleeping » money there is, the more the monetary system becomes sensitive to any shock at all.