INFLATION: What Lurks Ahead of us?

by Chris Black

TLDR: The US Dollar is facing potentially huge inflation rates which have not been seen by the dollar since the Federal Reserve started measuring inflation due to the disparity between massively increased (+400%) money supply and massively decreased (-88%) velocity of money which will rebound causing an increase in the general price level IF the Federal Reserve does not pull several trillion dollars from circulation.

     The basic theory of inflation is this, that inflation is a phenomenon which is created by changes to three things: Real GDP (Y), velocity of money (V), and chiefly money supply (M). There is a common fallacy that wages and commodity prices are the drivers of inflation, however  these two things are in reality expressions of something called the, “price level,” (P). Now that we have established the four variables at play when thinking about inflation, let’s define them. Guess what it means if the price level increases, that’s right a general increase in all prices is synonymous with: Inflation.

Y: The total amount of final goods and services produced in a geographic area, typically a country, in a given time period, typically one year.

V: The amount of times that a basic unit of currency (i.e.: one single dollar) is exchanged in a given period.

M: The total supply of liquid cash held by a population.

P: The average price across all goods and services produced in an economy.

     Now that we know what these variables mean, we can begin to model them mathematically. Our typical equation for modeling changes in inflation is written as follows: M+V=P+Y

     Now we acquire data regarding the percent change of these values, except for (P) which models expected inflation. According to the Federal Reserve itself, the money supply has increased by roughly 16 trillion dollars, or 400%, from February 2020 to present. During this same period the velocity of money has decreased by roughly 88% in this same period. GDP has (according to the Federal Reserve) increased by 12% during this period.

 Here we need to cover some basic economic functions and strategy of the Federal Reserve during the Covid-19 pandemic and shutdowns. The Fed essentially introduced sixteen trillion dollars into the economy to avoid a huge GDP crush or runaway deflation from plummeting velocity. In general, the goal of the Fed regarding inflation is to keep inflation predictable to decrease the barriers to enter into long-term contracts. 

To achieve this during the plummeting velocity of the Covid years, the Fed introduced trillions of dollars to circulation to balance the equation. Now, we can expect velocity to return to normal since the economic black swan event of Covid-19 and resultant shutdowns are receding, this means we will probably, over the course of one or two years see a several hundred percent increase in V. In order to counteract this, the Fed MUST find a way to pull at least several trillion dollars out of circulation or risk seeing hyperinflation.

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     At this point we can substitute these percent change values into our formula and easily calculate an inflation rate for the intermediate term that assumes the federal reserve will NOT decrease the money supply to counteract an increase in the price level i.e.: Inflation.

From M+V=P+Y we get this from our substitutions: 400+(-88)=P+12

     In order to balance our equation we would need a percent change value for the (P) price level of positive 900, this means a potential positive inflation rate of roughly 900% could occur in the next several years if the Fed fails to pull any money out of circulation and net growth of (M) remains where it is currently, AND the velocity of money returns to pre-Covid levels which would require a percent change of roughly 500%, which makes our expected equation in this case: 400+500=P+12

     So, the Fed has a tall order in front of it if it wants to avoid hyperinflation as it would need to, in parity with increasing velocity, pull those extra 16 trillion dollars from circulation somehow.

This is in no way intended to claim that the dollar is unequivocally going to see massive inflation in the next few years, all of these numbers are rough estimates derived from official Federal Reserve information based partially on the monetary theory of inflation. 

We may well only see inflation rates around 10-20% if the Federal Reserve can drum up the political willpower to mitigate this potential catastrophe. 

However, while we do not offer any financial advice here, it is potentially a very, very bad time to be holding lots of liquid cash.



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