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Is the Velocity of Money the "Elephant in the Room"?

John Blank

Today, I want to do something different.  The editors and readers at Zacks.com, and the investing public more generally, know well the Fed taper is coming to our financial markets.  It is kind of like a blockbuster movie.  Everyone has read about it and anticipates its arrival for months.

The big Fed idea at play?  

Stop printing as much Fed money and slow down buying long-term bonds with it.  The less bonds the Fed purchases, the higher go  long-term interest rates.   That part of the taper we have already seen.  Interest rates have moved up 1.3% on the 10-year US Treasury since the early May signal of a Fed taper.  

The Fed has been at this for years now, you know that.  That has left the U.S. markets will trillions of dollars in excess liquidity.

"Inflation Hawks" have been saying for some time that a big inflation is in store for us in the future.  The link between money and inflation has been made by a fundamental economics equation.  What this equation says it that the prices we pay for things (inflation), times the amount of things we buy (real GDP), must equal the liquid cash we have (money), times the number of times we use that quantity of money (velocity).

Inflation * Real GDP =  Money * Velocity  

This is called the quantity theory of money.  If the quantity of money goes up, then inflation  goes up, as long as real GDP growth and what is called the velocity of money (the amount of times you use money) is held constant.  That is what has gotten the gold markets and the inflation hawks generally all excited the last few years.  

That leads us to the following chart (I pulled it from the St. Louis Fed).  It shows us what has happened to the velocity of money.  Since 2008, as you can see, velocity has plummeted.  That meant that the huge amounts of money printed by the Fed wasn't been used as often, or at all.  

That kept inflation at bay.

See below:

My RTI question:  

With the Fed slowing down the printing press, what happens to the velocity of money?

Do you think the velocity of money will pick up and cause inflation?  Or will the velocity stabilize?  Or will it continue to fall like in the chart above?  We don't actually use the excess liquidity now, so it doesn't cause inflation..... yet.

Is the velocity of money the "Elephant in the Room"?

Share your thoughts below ....
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