Friday, April 16, 2010

The counterintuitive relationship between money growth and inflation


While on the subject of commodities, monetary policy, and inflation, I thought I would update this chart that compares M2 growth (M2 being arguably the best measure of money) and consumer price inflation. What strikes me in this chart is the strong tendency of these two lines to move in opposite directions. For example, M2 growth surged from 1995 through 1999, yet inflation fell; very slow M2 growth from 2004 through 2006 was accompanied by rising inflation; M2 growth plunged in 2009, yet inflation surged.

My explanation for this is that money velocity is what is really at work behind the scenes. M2 is typically called a measure of money supply, but it really is a better measure of money demand. When M2 growth slows, it is because money demand is slowing and money velocity (money velocity being the inverse of money demand) is rising. Rising velocity makes a given amount of money support a higher level of prices. Rising velocity is also indicative of a phenomenon in which people try to reduce their money balances in favor of owning more things, and that is a classic symptom of inflationary psychology.

So the fact that M2 growth has been almost zero over the past six months, and only 2% over the past year is both encouraging and troubling at the same time. That's because it means that the velocity of money has turned up sharply, and that in turn is helping to fuel more spending and higher prices.

24 comments:

Jake said...

Scott- isn't another thought that money supply is controlled by the Fed and the Fed has a mandate to target inflation in the 2% range. As a result when inflation rises, the Fed removes money (which raises rates) and when inflation falls the Fed supplies money (which reduces rates)?

Benjamin said...

This chart reads like mud thrown on a dirt floor at night.

You detect a pattern, or counterintuitive pattern, or chimera of a relationship?

My said...

Hahaha. You succumb to the naive perspective that correlation equals causation. First of all M1 is the best measurement of money because it is what is actually available for people to pay their bills. Secondly, we do not and have not had inflation by its true definition in this country for thirty years. Our economy has been deflating for over thirty years and it is simply that expansion of credit over that period of time that has kept it from collapsing. That, my friend, is not inflation. That is a debt bubble followed by a collapse in prices. Look down at your belly. See it inflating as you breathe? That is the only inflation in the American economy. Watch and learn...

Fullcarry said...

I have made this same point many times. M2 includes MMMFs which is definitely a reflection of money demand.

Short term instruments when owned by banks don't get counted as money, but when owned by MMMFs, they do. Hence the M2 anomoly.

A much better measure of money supply is TMS. Check it out http://is.gd/b4cIn .

Public Library said...

My,

That is one hilarious comment. "Look down at your belly"

Classic stuff!

Matt Young said...

There should be a money supply chain in the definition somewhere, long term money distributed down to short term money, and money can flow in reverse in this supply chain.
So when M(short term) builds up, it pushes back into M(longer term).

This model should exist, but I mainly get confused definitions of Mx when I look.

Right? Am I wrong?

Scott Grannis said...

Jake: that's almost exactly the way things are supposed to work. One exception: a proactive Fed shouldn't wait for inflation to rise before reducing bank reserves and thus raising short-term interest rates. Another exception: draining reserves doesn't always result in a reduced money supply. Another exception: inflation can go up even if money supply doesn't grow very much (because velocity rises).

Scott Grannis said...

My: I think that the process I have described is only of correlation: higher inflation, which usually means higher growth in nominal GDP, is possible without a corresponding increase in money, because velocity can make up the difference.

There is no rule that says M1 is the best measure of money. My research over the years points me to M2 as the most reliable indicator.

I think you are confusing "credit expansion" with money creation. The two are completely different. Money expands only if the Fed allows it to. Credit can expand at the whim of the private sector. If the Fed is doing its job, credit expansion has no implications for inflation.

DaleW said...

Or maybe the inflation we had since 2002 or so had nothing to do with American monetary policy and everything to do with increasing emerging markets demand for raw materials and not enough supply. It would be interesting to aggregate money supply statistics from across the world and then look at inflation on a region-by-region basis. While we are not seeing inflation in the US with the expansion of money supply globally, we are certainly seeing it elsewhere. Given the US is still in balance sheet repair mode and probably will be for a while, that is to be expected. Credit-satiated economies don't respond to monetary stimulus.

ronrasch said...

Scott this supports your long term thesis that the fed needs to raise short term rates in order to prevent inflation. I see inflation in the things that I buy. I do think though that there is some probability of a melt down of the financial system. If a meltdown happened, it wolud of course be deflationary. Then I think the government would be monetizing the debt to get out of it but who knows.

dr. j said...

Tea Party Question: If 40% of the population does not pay any Federal Income Tax, do they have any right to comment about what the government does or does not do with money? Bailouts and debt are not their burden. They are observers with absolutely no skin in the game or obligation to pay for the debt that is created. So, without taxation do they merit representation? Should they simply just shut up and let the taxpayers duke it out?

Public Library said...

Scott,

What are your thoughts on Goldman?

John said...

Public Library,

Scott had a comment on your question under the "more signs of a housing bottom" thread.

Benjamin said...

Dr. J:

Many people pay payroll taxes, and excise taxes, even if they pay no income taxes. Federal gasoline taxes.

I see no Constitutional way to deprive people of representation in a democracy on the basis of how much income tax they pay.

As a strict constructionist, I find such sentiments appalling.

I would like to see the USA move to a system of consumption taxes, rather than income taxes. Milton Friedman considered consumption taxes the least destructive form of taxation, and thought progressive consumption taxes the way to finance military outlays.

dr. j said...

Benjamin: What does being a Constructionist have to do with the question. If people pay SS and Medicare they have skin in that game. If they do not pay Income Taxes and will not be on the hook for the Federal debt, the question is, do they have a voice in those matters? Can tyranny be wielded by those who may noting into a given system, but have a say in that system? The question was prompted by the anger about bailouts and the health care "reform" by both sides. Quite a lot of the outcry was from people who have not financial stake at all.

As far as representation, and Constructionist views, how does one justify women voting while the constitution said nothing of this? Isn't giving women the vote based on interpreting the constitution according to today's values and mores?

李妍妮 said...

青春一逝不復返,事業一失難有成。......................................................

John said...

Thank you for such an illuminating contribution.

My said...

M2 is too broad of a measurement when attempting to define velocity. What "research" leads you to believe M2 is tbe best measurement of money when talking about velocity? M1 is the only accurate money component when referring to velocity. It's no coincidence the Federal Reserve does not measure M2 velocity. It's an oxymoron. And so is the Mises TMS when talking about velocity. It's no surprise because there aren't many people who really understand money. If you believe the velocity of money is picking up momentum, you need to get out in the real world. What detailed explanation do you have for the velocity of money rising?

Finally, I think you are confusing credit expansion with the expansion of money. We have a credit/debt based monetary system. By definition, when we have an increase in demand for credit, we have an increase in money. It may show up different ways in the aggregates because credit often isn't used in ways that M1 or M2 would capture that rise in credit and money. But, if you really understand the definition of inflation, you would know we haven't had inflation in over thirty years. And were we not to have created this massive financial bubble that has been instead building in lieu of inflation for the last thirty years, American economic output would have peaked thirty years ago. The expansion of money has been increasing while the economy has been stagnant at best. You are going to learn a few lessons on coming years as the American and global economy collapses in the face of your supposed increase in the velocity of money. You live in a hazy world defined by this bubble .....

Scott Grannis said...

My: you sound awfully confident for someone who doesn't know much, if anything, about the subject.

Benjamin said...

Well, being a strict constructionist, I believe in one man, one vote. For me, that is the end of the discussion.

Beyond that, people do pay federal taxes, beyond income taxes, such as payroll and gasoline taxes.

Beyond even that, would you deny stay-at-home housewives (with no income to report) the right to vote? Just exactly do you go about parsing this right to vote?

Some years, business operators have losses, and pay no federal income taxes (this has happened to me). They lose the right to vote? You are going to take away my right to vote because I had a down year?

I would rather stay within the confines of the Constitution. We can solve our problems without denying people the right to vote. That is a slippery slope you are on. Ar you are Tea Party man?

My said...

Hahaha. This is from someone who is unable to provide specifics when I ask your rationale behind your broad sweeping statements without any reasoning behind them. I guess ad hominem attacks work when you are unable to back up your statements with any detailed knowledge.

Let's just say while you were busy counting your money, I was busy publicly calling all of the crises around the world that would happen.

I am extremely confident in my understanding of science and how the world actually works. I don't base my remarks on ad hominem attacks or opinions without merit.

Live and learn.

Cheers

John said...

My,

You have obviously lived a long, long time....I'd say maybe..19.

maybe.

dr. j said...

Benjamin: If you read the posts, they pose questions, not assertions. What prompted the questions was the observation that the left and the right have an enourmous amount of people who are very vocal about what to do with other peoples money. The tea party wants supporters seem to support SS and Medicare and the Left seems to support new and expanding programs. The question is, why aren't people voting with their wallets by WRITING checks to support the programs they so love. If you like SS, don't waste my time telling me about lower taxes and less government and if you are on the left don't tell me what you want done with my money unless you write a check to the feds, too. I am not a Tea Party supporter, but I do love the idea of many people from the entire spectrum speaking their minds. I think I remember someone important saying "I may not agree with them, but I would defend to the death their right to say it." Re: women and the vote, it was an example of how the culture and its changes, over time, have been interpreted, constitutionally, to include more citizens. Some people might think that sounds like legislating from the bench. I do not. Thanks for the comments back.

W.E. Heasley said...

Mr. Grannis:

Excellent analysis.

Yes, it is counterintuitive like some many items in the field of economics.

Velocity just doesn’t get headlines. However, velocity is a very, very interesting phenomena.