Velocity of Money

[inflationhawk]

While inflation can be seen in some prices due to supply/demand issues within a specific universe (commodities such as gasoline, certain food products, etc.)...I believe widespread inflation won't be seen until the velocity of money increases. The Fed may be pumping money into the economy, but as they say you can lead a horse to water, but you can't make him drink. The velocity of money is slowing faster than the Fed can pump money in the system. And the money that is making it there is being hoarded by the banks and used as trading cash which is pumping up commodities prices. Printing money by itself doesn't create widespread inflation, it also takes circulation and velocity of that money to create the economic activity to drive inflation higher across the board. I find this chart to be very helpful... http://research.stlouisfed.org/fred2/se ... ?cid=32242

[68Camaro]

There is truth to this, though eventually the dam will break and it will literally flood out...

[Delawhere Jack]

Two of my favorite signature lines I use in email:

The most important thing to remember is that inflation is not an act of God; inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.

-Ludwig von MIses, Ecomonic Policy

and

"Inflation is always and everywhere a monetary phenomenon."

Milton Friedman

Price changes due to fluctuations in supply and demand are a completely separate issue than inflation. You're right, the FED is pumping money... into the banks. I believe one of the factors that has prevented (delayed?) a surge in monetary velocity is the free-fall of real estate valuations.

I had an attorney that I worked with tell me about a year or two ago he saw major deflation coming for as far as he could see. I WAS solidly in the inflation-hyperinflation camp at the time. I'm beginning to believe he may be right.

I know this is anecdotal, but I was visiting my sister last week in Maryland on the Delmarva penninsula. Her husband has quite a number of residential building lots he still owns, left over from the housing boom, plus some commercial properties and their home. He had just received his tax appraisals from Maryland on approx. 20 properties, and the assessed values had dropped roughly 40%..... since 2008! He said that he is going to appeal to have many of the appraisals lowered even further based on comparable sales in the area.

Long story short, I'm beginning to think that even with the tremendous amount of "printing" the FED has done (and continues to do, discreetly), with things as they are now, all of this money will only serve to keep TBTF banks and the gubbernment "solvent".

OTOH, foreigners are dropping UST like a bad habit, so what do I know.

[inflationhawk]

Jack, I'm in your camp. I too thought we were on the road to major inflation, but now have doubts. Milton Friedman did the majority of his work during a time when the velocity of money was pretty constant and not volatile. I believe he did not take into account large swings in velocity when stating that inflation was always a monetary phenomenon.

[68Camaro]

As has been observed in other threads, over a given finite period of time it is possible to have one segment of the economy deflating while another inflates. We have that now, with real estate deflating, while many commodities are inflating.

[inflationhawk]

My overall point is that inflation is not just about printing money, but its also about what happens with the velocity of that money. Currently despite how much money we have printed in the last few years, with the decrease in the velocity of money it hasn't caused widespread inflation. The debts of the banks have merely been transferred to the government and the banks have new money which they are trading with (or hoarding to clean up their balance sheets) rather than lending it to the economy at large and increasing the velocity of money. Inflation in commodities and the rise of the stock market from its lows have been about the only result of the added funds because of those trading activities.

Someday this may change and if funds do make it to the economy via lending, the velocity of money will start to increase. It remains to be seen if the Fed can pull all the money back out quick enough (via higher interest rates) to keep inflation at bay. In the meantime, if global markets decide to demand a higher return to buy US treasuries because of our debt levels, and drive interest rates up, then I believe we could see a double whammy of less money flowing into the economy by the Fed and a slow velocity of money….a deflation scenario for sure.

[Delawhere Jack]

Well, ultimately we will see signifigant inflation, and as 68Camaro pointed out, what we are seeing now is commodity inflation concurrent with asset deflation.

What we all need to keep in mind is that governments (ie monetary masters and slaves) - federal, state and local - lose revenue in a deflationary environment. This is something they WILL NOT ABIDE. So, we may be getting a short term reprieve due to asset deflation, but eventually we will be faced with massive inflation across the board.

[theo]

Correct me if I'm wrong but the only real deflation we've seen is in property values which are coming down from where they never should have been in the first place. Also, much of the nation has not seen the dramatic 40% to 50% price declines that occurred on the coasts. In western Pa, home prices are on average where they were in 2007. My house was appraised last year for 10% higher than what we brought for in 2005. I thought this was a little high, but I know we could sell our place at least for our original purchase price.

It is my understanding that inflation/deflation is measured by the monetary base, which I believe has increased. The impact on prices is only a side effect. The deflation argument is pretty thin IMHO when all that supports it are price declines in formally over-priced beach houses and McMansions. I believe that sustained, wide-spread deflation can only occur with a stable, if not static monetary base; something that central banking denies us.

I agree that the velocity of money is an important concept that does not get enough attention. However, increased velocity of money is more of a response to than cause of inflation. It often signals that people have lost confidence in money in that they would rather spend it than hold it as a store of value. If left unchecked, this behavior will lead to hyperinflation.

[68Camaro]

Correct me if I'm wrong but the only real deflation we've seen is in property values which are coming down from where they never should have been in the first place. Also, much of the nation has not seen the dramatic 40% to 50% price declines that occurred on the coasts. In western Pa, home prices are on average where they were in 2007. My house was appraised last year for 10% higher than what we brought for in 2005. I thought this was a little high, but I know we could sell our place at least for our original purchase price.

It is my understanding that inflation/deflation is measured by the monetary base, which I believe has increased. The impact on prices is only a side effect. The deflation argument is pretty thin IMHO when all that supports it are price declines in formally over-priced beach houses and McMansions. I believe that sustained, wide-spread deflation can only occur with a stable, if not static monetary base; something that central banking denies us.

I agree that the velocity of money is an important concept that does not get enough attention. However, increased velocity of money is more of a response to than cause of inflation. It often signals that people have lost confidence in money in that they would rather spend it than hold it as a store of value. If left unchecked, this behavior will lead to hyperinflation.

If everything you said was true I would agree, but many of your assertions are simply not correct. Property values in the midwest (which Western PA is, nearly) may well have been less affected both on way up as well as down, and that is also my understanding. So consider yourself fortunate. However, that doesn't apply to a large population of the US - and not just "beach houses and McMansions". Fact is that prices here nearly uniformly dropped to well below the pre-boom prices, and have been lower than the cost of new construction for several years. That is true deflation. That you haven't experienced it doesn't mean it isn't real. Again, consider yourself fortunate. Perhaps the deflation here is a transitory event that will, itself, correct - I hope so, but much of the damage has been done for a large part of the population.

There are many measures of inflation that differ slightly, but they tend to lead the same thing, just being out of phase with each other. But fact is that unless the whatever definition is used eventually manifests itself in the cost of goods, then it is a bad definition.

[inflationhawk]

Inflation/deflation can be measured solely by the monetary base only if the velocity of money remains constant. Milton Friedman had every reason to make his statement because for about 30 years through several expansions and contractions the velocity of money did remain roughly the same. That's definitely not the case anymore as the velocity of money has become more volatile. Velocity of money is just as important of an affect on whether there is price inflation/deflation as the monetary base. The measure of the monetary base is really meaningless by itself as the same dollars can be utilized over and over in the economy affecting prices. Likewise, the velocity of money is meaningless without factoring in the monetary base.

Thus far the Fed has offset the decrease in the velocity of money by increasing the money supply and prices overall have not had dramatic changes. There are some pockets of inflation (commodities) and some pockets of deflation (housing), but overall the affects have been somewhat offset. I believe it's unsustainable for the Fed to always get it right.

Scenarios that could lead to inflation or even hyperinflation:
1) An unexpected pick-up in the velocity of money
2) The Fed "overestimates" the velocity of money decrease and monetizes the debt too much

OR

Scenarios that could lead to deflation
1) An unexpected decrease in the velocity of money
2) The Fed is unable to keep up with the velocity of money decrease

I can see a possibility for any of the above scenarios. I was formerly in the inflation camp, but am now leaning more towards the deflation camp. I don't expect to be able to predict the future with certainty, so I will prepare for both scenarios. I do believe that at the end of a deflationary cycle, an inflationary period is certain to come and over long periods of time inflation has always far surpassed deflation. Which comes first is the question of the day/month/year/decade. I just want to have the ability to take advantage of whichever scenario presents itself.

[theo]

Correct me if I'm wrong but the only real deflation we've seen is in property values which are coming down from where they never should have been in the first place. Also, much of the nation has not seen the dramatic 40% to 50% price declines that occurred on the coasts. In western Pa, home prices are on average where they were in 2007. My house was appraised last year for 10% higher than what we brought for in 2005. I thought this was a little high, but I know we could sell our place at least for our original purchase price.

It is my understanding that inflation/deflation is measured by the monetary base, which I believe has increased. The impact on prices is only a side effect. The deflation argument is pretty thin IMHO when all that supports it are price declines in formally over-priced beach houses and McMansions. I believe that sustained, wide-spread deflation can only occur with a stable, if not static monetary base; something that central banking denies us.

I agree that the velocity of money is an important concept that does not get enough attention. However, increased velocity of money is more of a response to than cause of inflation. It often signals that people have lost confidence in money in that they would rather spend it than hold it as a store of value. If left unchecked, this behavior will lead to hyperinflation.

If everything you said was true I would agree, but many of your assertions are simply not correct. Property values in the midwest (which Western PA is, nearly) may well have been less affected both on way up as well as down, and that is also my understanding. So consider yourself fortunate. However, that doesn't apply to a large population of the US - and not just "beach houses and McMansions". Fact is that prices here nearly uniformly dropped to well below the pre-boom prices, and have been lower than the cost of new construction for several years. That is true deflation. That you haven't experienced it doesn't mean it isn't real. Again, consider yourself fortunate. Perhaps the deflation here is a transitory event that will, itself, correct - I hope so, but much of the damage has been done for a large part of the population.

There are many measures of inflation that differ slightly, but they tend to lead the same thing, just being out of phase with each other. But fact is that unless the whatever definition is used eventually manifests itself in the cost of goods, then it is a bad definition.

Perhaps I shouldn't have used myself as an example, but stating that I don't acknowledge deflation simply because you assume it hasn't effected me is a little unfair. I don't think I'm quite that simplistic.

Anyway, I think we may agree more than you realize. I did not deny that we have had serious deflation in property values. I merely pointed out that deflation in one sector (even an one as important as RE) is not necessarily an effective argument for deflation in the economy as a whole. The decreasing housing values have not stopped food prices from increasing or energy prices from moving back toward their old highs. I do agree, however, that this decline was perhaps one factor that has kept serious inflation at bay, at least for now.

However, I think the decrease has been anything but uninform. From what I've read the collapse in house values seem have been led by the over-supply in new construction (that I crassly characterized as McMansions) especially in boom/bust places like Arizona and California along with properties in resort areas, especially on the coasts(vacation homes). That is where you get the dramatic examples of 40% and 50% price collapses. I agree that most homes have suffered some decrease in value, but I believe that the average is much closer to 10%, bad enough to put many under water and cause a rash of foreclosures, but not the nation-wide collapse characterized by some.

[theo]

Inflation/deflation can be measured solely by the monetary base only if the velocity of money remains constant. Milton Friedman had every reason to make his statement because for about 30 years through several expansions and contractions the velocity of money did remain roughly the same. That's definitely not the case anymore as the velocity of money has become more volatile. Velocity of money is just as important of an affect on whether there is price inflation/deflation as the monetary base. The measure of the monetary base is really meaningless by itself as the same dollars can be utilized over and over in the economy affecting prices. Likewise, the velocity of money is meaningless without factoring in the monetary base.

Thus far the Fed has offset the decrease in the velocity of money by increasing the money supply and prices overall have not had dramatic changes. There are some pockets of inflation (commodities) and some pockets of deflation (housing), but overall the affects have been somewhat offset. I believe it's unsustainable for the Fed to always get it right.

Scenarios that could lead to inflation or even hyperinflation:
1) An unexpected pick-up in the velocity of money
2) The Fed "overestimates" the velocity of money decrease and monetizes the debt too much

OR

Scenarios that could lead to deflation
1) An unexpected decrease in the velocity of money
2) The Fed is unable to keep up with the velocity of money decrease

I can see a possibility for any of the above scenarios. I was formerly in the inflation camp, but am now leaning more towards the deflation camp. I don't expect to be able to predict the future with certainty, so I will prepare for both scenarios. I do believe that at the end of a deflationary cycle, an inflationary period is certain to come and over long periods of time inflation has always far surpassed deflation. Which comes first is the question of the day/month/year/decade. I just want to have the ability to take advantage of whichever scenario presents itself.

Nice post. Thanks!

I agree that in the short-run, velocity has a dramatic impact on prices. However, even if velocity is volatile, the ups and downs are likely to cancel each other out in the longer term. The past five years is a good example. I think the relationship between the monetary base and the general price level has a better correlation in the long-run. Also, as I implied before, the size of the monetary base could have an impact on the velocity. Our growing national debt causes an automatic expansion of the monetary base and, more importantly, serves as a very public indictment of the U.S. dollar. As a result velocity will increase as people are less willing to hold dollars as a store of value. Conversely, if monetary base is decreased for whatever reason, people are less willing to part with "scarce" dollars. This decreases velocity.

[68Camaro]

However, I think the decrease has been anything but uninform. From what I've read the collapse in house values seem have been led by the over-supply in new construction (that I crassly characterized as McMansions) especially in boom/bust places like Arizona and California along with properties in resort areas, especially on the coasts(vacation homes). That is where you get the dramatic examples of 40% and 50% price collapses. I agree that most homes have suffered some decrease in value, but I believe that the average is much closer to 10%, bad enough to put many under water and cause a rash of foreclosures, but not the nation-wide collapse characterized by some.

From our past posts, I think we agree on a great many things. I just think you're a bit sheltered up there in Western PA with regard to the size and extent of the housing bust. Regardless of the cause, or uniformity it exists, and it is uniform enough that it affected the entire state of Florida - at least all the metro statistical areas that 90% of the state lives in. I really don't think you have a conception of how bad it got (and still is). Most residental property values in FL dropped by 40-50%, or more, not 10. I can attest to that first hand on several homes I had, have, sold, bought, or been privy to, and really you just need to pick a county and look at the web property appraiser reports to see how widespread this is. Down in Coral Gables, admittedly one of worst areas in the country (but not that much worse than here), there were miles and miles of partially completed subdivisions with thousands of houses in various states from brand-new, never lived in to partial builds to foreclosed and gutted by owners. I went through that area two years ago looking for a possible buy. It was so depressing that I couldn't stand to buy one there, even though I literally could have bought a beautiful, brand new, never lived in, 1600 sq ft fully optioned ranch house for $65,000 - 10 grand less than I paid for my first similar new house that I built in 1985, 25 years prior. Most of those houses weren't sold fast enough to matter, and caught in limbo they weren't cared for, and became insect infested, mold-filled nightmares that I wouldn't touch with a 10-foot pole now.

[inflationhawk]

I agree that in the short-run, velocity has a dramatic impact on prices. However, even if velocity is volatile, the ups and downs are likely to cancel each other out in the longer term. The past five years is a good example. I think the relationship between the monetary base and the general price level has a better correlation in the long-run. Also, as I implied before, the size of the monetary base could have an impact on the velocity. Our growing national debt causes an automatic expansion of the monetary base and, more importantly, serves as a very public indictment of the U.S. dollar. As a result velocity will increase as people are less willing to hold dollars as a store of value. Conversely, if monetary base is decreased for whatever reason, people are less willing to part with "scarce" dollars. This decreases velocity.

The past five years the velocity of money has steadily decreased from 1.95 to 1.6, there was a brief move up from 1.65 to 1.7 between 2009 and 2010 before it started falling again. Note how the move in velocity aligned with the fall and recovery in stock prices, although stocks recovered more quickly than the velocity of money has. I believe that can be explained by the trading activities of the banks that used the injection of money by the Fed to trade on their own books as opposed to lending money out to businesses.

I have a difficult time seeing that the monetary base itself has a direct impact on the velocity of money in today's economy and other factors have a bigger impact. I feel the overriding factor in determining the velocity of money is the perception of the return one can get on those funds in relation to risk. In an extreme scenario like hyperinflation, I could see if people perceived the monetary base as expanding too quickly and prices were rapidly appreciating that would increase the velocity to which they vacated their dollars. I don't see that being a driver in today's market (at least not yet). In fact, the dollar index has been strengthening recently and is at the same place it was 5 years ago.

Your posts and responses have been a great read and I appreciate your debate. It gets me thinking and helps me think through all the possible scenarios, thanks!

[Engineer]

Good post Inflationhawk.

I'm pretty sure the government encourages commodity inflation as a way to prop up velocity. Benny and the inkjets have stated MANY times that they're worried about deflation more than inflation. The Fed's overnight loans to the banks to drive up commodity prices appears to be a great way to bail out the TBTF banks while simultaneously increasing worldwide money velocity through higher commodity prices.

Looking at it that way, the whole world is bailing the banks out of their bad loans through a hidden inflation tax on their food and fuel.

[inflationhawk]

Well, the whole world is suffering from the hidden tax of inflation on food and fuel as a result of banks getting bailed out by the US government. The whole world isn't really bailing out the banks, it's not like they have a choice, it's the US government that's imposing the result of inflation upon them...I believe we are saying the same thing here and I agree. When I read your statement it makes me think the whole world had a choice in the matter!

[theo]

However, I think the decrease has been anything but uninform. From what I've read the collapse in house values seem have been led by the over-supply in new construction (that I crassly characterized as McMansions) especially in boom/bust places like Arizona and California along with properties in resort areas, especially on the coasts(vacation homes). That is where you get the dramatic examples of 40% and 50% price collapses. I agree that most homes have suffered some decrease in value, but I believe that the average is much closer to 10%, bad enough to put many under water and cause a rash of foreclosures, but not the nation-wide collapse characterized by some.

From our past posts, I think we agree on a great many things. I just think you're a bit sheltered up there in Western PA with regard to the size and extent of the housing bust. Regardless of the cause, or uniformity it exists, and it is uniform enough that it affected the entire state of Florida - at least all the metro statistical areas that 90% of the state lives in. I really don't think you have a conception of how bad it got (and still is). Most residental property values in FL dropped by 40-50%, or more, not 10. I can attest to that first hand on several homes I had, have, sold, bought, or been privy to, and really you just need to pick a county and look at the web property appraiser reports to see how widespread this is. Down in Coral Gables, admittedly one of worst areas in the country (but not that much worse than here), there were miles and miles of partially completed subdivisions with thousands of houses in various states from brand-new, never lived in to partial builds to foreclosed and gutted by owners. I went through that area two years ago looking for a possible buy. It was so depressing that I couldn't stand to buy one there, even though I literally could have bought a beautiful, brand new, never lived in, 1600 sq ft fully optioned ranch house for $65,000 - 10 grand less than I paid for my first similar new house that I built in 1985, 25 years prior. Most of those houses weren't sold fast enough to matter, and caught in limbo they weren't cared for, and became insect infested, mold-filled nightmares that I wouldn't touch with a 10-foot pole now.

Wow! I knew Florida was bad, but it sounds like it is right up with stories I've heard about Arizona and Las Vegas. It all sounds very sad. I shouldn't have been surprised as I've noticed that quite a few banks in Georgia and Florida have gone under as a result of financing the Florida RE boom/bust. My impression is that areas dependant on tourism seem to have been hit hardest by the real estate bust, certain parts of Florida among them.

[68Camaro]

Brain fart - I wrote Coral Gables, when I re-read I realized I meant Cape Coral in my story above. No idea how Coral Cables is/was, but suspect somewhat less dramatic than the situation in Cape Coral. Cape Coral is on the West Coast of FL a couple hours south of Tampa and part of the Naples/Boca area; Coral Gables on the East as part of the Miami metro area.

[Lemon Thrower]

While inflation can be seen in some prices due to supply/demand issues within a specific universe (commodities such as gasoline, certain food products, etc.)...I believe widespread inflation won't be seen until the velocity of money increases.

yes, i completely agree although i would say that inflation is widespread now although modest compared to where it is likely to go.

The velocity of money is slowing faster than the Fed can pump money in the system. And the money that is making it there is being hoarded by the banks and used as trading cash which is pumping up commodities prices. Printing money by itself doesn't create widespread inflation, it also takes circulation and velocity of that money to create the economic activity to drive inflation higher across the board. I find this chart to be very helpful... http://research.stlouisfed.org/fred2/se ... ?cid=32242

The chart shows that velocity of money has slowed. if you look at a longer term chart, it was relatively constant for 50+ years.

[theo]

Facinating chart from Lemon Thower. Its seems to, at least in part, confirm Inflationhawk's premise that it correlates with bull markets in stocks. For example you see a large spike in mid to late 90s, which, I believe correlates with the tech bubble. However, there was a significant spike from the mid 1970s to the early 80s which seems to correlate with the run up in PM prices. I'll have to check, but I don't believe there was a major bull market at that time.

[68Camaro]

Late 70s into the mid 80s (with a couple years off for recession in the middle of this) was a (correction) stagflationary period - market was fairly flat, prices were increasing, interest rates were 10%+ (up to upper teens by mid 1985). Mortgage rates on that first home I built in 1985 were 9.5% when ground was broken in early 85, and 14.5% by the time we closed 4 months later - that nearly killed me until I could refinance a couple years later. Inflation was significant enough that twice per year "cost of living" raises were predominant circa 79-80 - anyone remember those besides me?

A chunk of the tech bubble run-up was inflation rather than profit.

The chart makes sense, but there are multiple causes mixed in with the effect.

[theo]

The past five years the velocity of money has steadily decreased from 1.95 to 1.6, there was a brief move up from 1.65 to 1.7 between 2009 and 2010 before it started falling again. Note how the move in velocity aligned with the fall and recovery in stock prices, although stocks recovered more quickly than the velocity of money has. I believe that can be explained by the trading activities of the banks that used the injection of money by the Fed to trade on their own books as opposed to lending money out to businesses.

I have a difficult time seeing that the monetary base itself has a direct impact on the velocity of money in today's economy and other factors have a bigger impact. I feel the overriding factor in determining the velocity of money is the perception of the return one can get on those funds in relation to risk. In an extreme scenario like hyperinflation, I could see if people perceived the monetary base as expanding too quickly and prices were rapidly appreciating that would increase the velocity to which they vacated their dollars. I don't see that being a driver in today's market (at least not yet). In fact, the dollar index has been strengthening recently and is at the same place it was 5 years ago.

Your posts and responses have been a great read and I appreciate your debate. It gets me thinking and helps me think through all the possible scenarios, thanks!

Thank you for the kind words.

Five years was, of course, not the best example. However, as someone else pointed out, the velocity is essentially where it was 50 years ago and yet the dollar buys about 80% less. The difference is due to the monetary base. Of course Keynes said "In the long run, we're all dead." However, I believe that this constant short-term focus distracts from the reality that centralized banking authorities are able to manipulate the value of our savings.

[68Camaro]

I think you guys have collectively hit the nail on the head, though you may not fully agree with each other. Velocity is an important discriminator in the short term, and it's a long-term indicator, but not necessary and sufficient in and of itself.

It's basically a rigged casino game, where only those that are aware, who pay attention, and who "card count" can eventually beat the house. Bad analogy maybe, but you get the gist. Let's hope they don't outlaw card counting or confiscate the proceeds on the way out the door.

[Lemon Thrower]

agreed, 68.

yes, velocity of money fell off a cliff.

i think the stock market is more closely correlated with credit (money) creation. money supply actually fell and people lost home equity and jobs so they stopped spending (as much).

one thing to be alert for is that the Fed needn't create actual inflation but only the expectation of actual inflation. that will get the economy moving again if they can do this through propoganda. but it doesn't fix any of the underlying imbalances, so prudence is the order of the day.

[cupronickel]

Once prices start to rise, and people realize the value of their currency is decreasing, they will rush to buy anything. It is only then that the velocity of money accelerates out of control.
There are stories from 1929 Germany of workers demanding to be paid at lunch time, so that they could go out to spend their paychecks before prices went up further.
The velocity of currency is just a way to measure the demand for that currency. There is no way that the Fed Reserve can pull back on supply, once the demand craters.
Usually, just the opposite happens, as the Gov't needs more money too as salaries and expenses increase.