Falling Inflation Takes Gold Down With It

This morning we learned that the Consumer Price Index declined at a 0.2% annual rate in March for an increase of 1.5% over the past year. Last week we learned that the Producer Price Index declined 0.6% in March for an increase of only 1.1% over the past year. The latest GDP price deflator, for the fourth quarter of 2012, was up at a 1.6% rate, for an increase of 1.7% for 2012. No wonder that gold, that great hedge against inflation, is under pressure. Wile E. Coyote finally looked down.

What about inflation right around the corner? Inflation has been right around the corner for years now. Let’s look at money supply growth for a clue. According to the Fed’s H.6 series on the money stock, M2 growth was 6.8% over the past 12 months, 5.7% (annual rate) over the past 6 months, and only 1.7% over the past 3 months. This deceleration in money growth coincides with the Fed’s new round of purchases and balance sheet expansion under QE3.

What about velocity? Has an increasing velocity increased the “effective” rate of M2 growth? Or has a declining velocity decreased the effective rate of money growth? In our recent experience, it has been the latter. The moderate growth in M2 (moderate under the circumstances) has been rendered even more moderate by declining velocity. In fact, the decline in velocity has been about half of the percentage growth in money.

Of course, money growth plus velocity growth equals nominal GDP growth. So, we need not look further than nominal GDP growth to view the combined growth of money and velocity. During 2011 and 2012, nominal GDP growth was 4%. That is roughly composed of 7% money growth minus an average 3% velocity decline. What happened in the fourth quarter of 2012, our latest measured quarter? Nominal or current dollar GDP—the sum of money growth plus velocity growth–increased only 1.4%. Not a lot of inflation in the pipeline, I would say.

The story doesn’t change if we used different measures of the money supply since the velocity offset would be proportionally greater. For example, M2 growth of 7% minus velocity change of 3% yields 4% total spending growth or nominal GDP growth. If M1 grew twice as fast as M2, at 14%, then the decline in velocity (by arithmetic) would be 10 percentage points.

So far, I’ve been talking about the left side of the equation of exchange—MV. Four percent growth in MV must be matched (by arithmetic) by a 4% change in the right side of the equation—PQ—where P is the average price level and Q is real GDP. Roughly speaking, the division between price increases and real GDP growth has been half and half. Over recent years, on average, we’ve had a 2% real growth economy with 2% inflation. The inflation component seems to be coming down. It remains to be seen whether the real component will rise to fill the gap or whether nominal GDP will fall below 4% for an extended period.

People who are surprised by the low and declining inflation rate, or think the numbers are cooked, probably base their doubts on the fact that the Fed has been printing boatloads of money and rapid money growth always leads to rising inflation. The problem is that the fact is not a fact at all. The Fed has not been printing boatloads of money, as I explained in my previous post.

Comments (13)

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  1. Jack says:

    I was under the impression that one of the purposes of Quantitative Easing was to create modest increases in inflation, in order to stimulate lending and prevent deflation. Are we splitting hairs between creating money by buying assets and printing money?

  2. Kyle says:

    It’s funny that a few years ago when Friedman died that the Fed said “its a good thing today’s policy makers understand the implications of his thinking.”

    More fiscal policy Mr. Bernanke, please. I haven’t had enough price instability yet.

  3. E. Carr says:

    Interesting. I just finished reading an article from the American Institute for Economic Research claiming that economic indicators suggest that inflation is rising. The article claims that growth of the M2 money supply has stalled despite Fed actions to increase the monetary base in hope that banks will loan more money and increase the money in circulation. The authors conclude that the “Fed is panicking”.

  4. Patek says:

    Interesting post, yes it may seem like the FED is printing boatloads of money, however, let’s not forget that we are a 16 trillion dollar economy, with major debts, and large expansion of the federal government, so we may be printing enough money to maintain this trend as oppose to welcoming inflation.

  5. Gabriel Odom says:

    If inflation is only at about 1.4% and falling, then why in the hell are federal student loans at 6.8%?

  6. Desai says:

    Do you think the demise of gold is a temporary thing?

  7. Sam Hyler says:

    “People who are surprised by the low and declining inflation rate, or think the numbers are cooked, probably base their doubts on the fact that the Fed has been printing boatloads of money and rapid money growth always leads to rising inflation. The problem is that the fact is not a fact at all. The Fed has not been printing boatloads of money, as I explained in my previous post.”

    Interesting and informative post. Thanks, Bob.

  8. Ron says:

    I think that gold will eventually lose most of its value. We will start valuing real resources like water much more in the future.

  9. Bridges says:

    Good read. I’m glad someone is pointing this out. The significant increase in some prices over the past few years has been a result of our government. Such as corn prices going up as a result of mandated ethanol in gasoline (created a shortage of corn that goes into foods and animal feed) and the biodiesel tax credits created a shortage of fats and cooking oils. (Oh, and health insurance prices were up last year, after a few years of declines).

    These price increases are supply shocks and not the demand-driven price increases that cause increases in long-term interest rates.

  10. Kyle says:

    @E. Carr
    Yeah, the point of QE was to push inflation. Banks were holding far more than there reserve requirements. So it wasn’t working all that well for the little people.

  11. Tomasz Gorski says:

    Hi Bob,thanks a lot for such a well researched write up. Was really confused about the inflation and the price fall of gold. No where did I find such scientific explanations with all these statistics. Though I’m personally not that interested in purchasing gold… but you know it’s always good to be informed!

  12. Dennis says:

    Relatively new to the macro perspective, but I still believe inflation could very well happen in the future. Just b/c the past has shown one direction doesn’t mean it’s evidence of the future. As I understand it, it matters if the cash in cash velocity and M2 money supplies existed pre-QE or created BY QE.

    I don’t doubt your numbers, but they could be measuring cash created by QE. But that would mean your numbers don’t matter b/c they primarily measuring money provided by QE. I believe Greg Ip from the economist wrote about this at one point (or Krugman from NYTimes).

    If savvy investors found a place to park their pre-QE cash that didn’t qualify for M2 designation, then that money isn’t considered. This is how I’ve understood it

    Alternatively, I’ve thought that perhaps maybe the Fed is in fact replacing cash that wasn’t really there (created by the 2008 bubble).

    Both have logical merit, but I believe the above will happen – just perhaps not HYPERish

  13. Tomasz Gorski says:

    Thanks for approving my comment. Keep up the good work. :)