As I’ve been trying to explain, the inflation we’ve seen so far may not be true inflation at all. And yet, true inflation is very much on the cards – a lot of it.
It’s important to distinguish between the two, before I explain why inflation is yet to strike.
Prices can rise because of supply and demand shifts, but that’s not inflation. Inflation is the devaluation of money itself, not shifts in supply and demand.
The fact that both these changes have the same symptom – rising prices – does not alter the fact that their cause is different. And a misdiagnosis of the cause leads to a disaster.
Of course, it may also be true that the inflation we’ve seen really is due to the devaluation of money. But you can’t determine this from the rising measure of inflation we happen to use – rising prices. Because prices can rise for all sorts of reasons.
As I see it, true inflation is yet to emerge. And it could spiral wildly out of control for a simple reason that very few people pay attention to.
Back in June I published an explanation of why inflation would continue to surge in Gold Stock Fortunes. It was all about something called the velocity of money.
Of course, I can’t reveal all here – that’s for paid-up subscribers.
But what I can do is outline the argument. And it’s time to do so, with the media and the blogosphere finally catching on.
You see, the velocity of money is by far the most important factor when it comes to inflation. And yet very few people pay any attention to it. Because it’s tough to measure, understand and explain in a newspaper article.
Here’s how I tackled it back in June:
The velocity of money refers to how fast, or often, money is spent. Some examples offer the best explanation for what this really means.
If [money] goes from being spent just once a day to twice a day, it feels like there is twice as much money sloshing around the economy. The money supply hasn’t increased, but it feels like it has doubled.
The velocity of money is what has changed in this example. The speed, or frequency, with which money is spent.
Let’s edge closer to what has actually happened during the pandemic (and also happened in 2008). Central banks created vast amounts of money under quantitative easing (QE). But it was saved instead of flying across shop counters. The fall in the velocity of money negated the increase in the money supply. More money was spent less often. The two immense forces offset each other. That’s why inflation didn’t emerge after 2008 and why it hadn’t during the pandemic (until recently) despite the vast QE.
It’s easy to understand that velocity plummeted during the pandemic. We weren’t allowed to buy a lot of stuff. And savings rates spiked. So money was spent less often, making the economy feel as if there were less of it.
The response was a huge increase in the money supply to offset this plunge in velocity.
To illustrate, imagine if the velocity of money halves, but the money supply doubles. This should balance out to no inflation because the two offset each other.
But as economies re-open post-pandemic, and the velocity of money starts to normalise as spending returns to normal, then what’ll happen to inflation?
“Does the Fed Have a Brewing Velocity Problem?” asks Steven Vannelli, CFA, in a blog. His message is that velocity may be normalising, which, after a pandemic, means rising.
Vannelli’s focus is on bank lending. Just as saving makes the velocity of money fall, lending by banks makes it rise. And banks are back in the lending market according to Vannelli and the data he cites.
In Gold Stock Fortunes I took readers through the simple equations that make it possible to calculate various scenarios for inflation, the velocity of money and the money supply. The implications for inflation were shocking. If the world goes back to normal in terms of spending, inflation will skyrocket.
But don’t worry, the central banks will just remove some of the fuel, right? They’ll just reduce the money supply to offset the rising velocity, just as they increased the money supply to offset falling velocity during the pandemic.
This is the crux of the matter, and what really keeps central bankers up at night. Because removing the vast amounts of money they have pumped into the economy to offset falling velocity would undermine what that money was used to buy.
Quantitative easing (QE) is, after all, performed by buying assets – usually government bonds. Thus, reversing QE involves selling them.
But in a world of high inflation, and central banks selling assets to reverse QE, interest rates on government bonds could skyrocket, bankrupting governments themselves.
I’ve asked you many times what I consider to be the big question investors face: what do you think central bankers will prioritise? Inflation or the solvency of their governments? Because a turn in velocity suggests they will have to choose.
Before we finish, there’s a new urgency to that question, which I also covered in Gold Stock Fortunes:
Here’s what you really need to understand about the velocity of money. As you can imagine, when inflation begins, people try to spend their money faster. They try to get rid of it quickly to avoid the loss of value from holding it. This means the velocity of money speeds up when inflation begins. Which, in turn, makes the same amount of money feel like even more money. And that only accelerates the inflation even more.
In other words, inflation has a self re-enforcing power to it. If it kicks off, people panic and make the problem worse.
So, the inflation spike we’ve seen so far could be the spark that ignites the huuuuge amount of fuel which central banks have pumped into the economy to fight off the falling velocity of money. But the two possible outcomes – high inflation and a sovereign debt crisis – have precisely opposite investment consequences.
Find out which result Nigel Farage and Rob Marstrand expect here.
Editor, Fortune & Freedom