What Causes Inflation?

So, this morning's blog post sparked the curiosity of yet another dear friend, who also reached out to me via email with an excellent question that I believe will also be instructive to the rest of our readers. 

Here you go:

Friend: So Marty, what happens when the Fed keeps printing money? Doesn’t it become play money...useless? What gives the Fed the right to do that? Unless you have something to back up all this “new money” it seems like it would be useless?


Me: That's the question; conventional wisdom says that printing more and more money, without an offsetting increase in the production of goods and services, has to mean the value of each dollar declines, or collapses, as there's more of them out there chasing essentially the same number of goods and services.

However, there's something missing in that equation (it assumes the chasing): For money to lose its value in such a scenario, it has to be used to buy goods and services. 

The measure of the extent of its use is called the "velocity of money". In a nutshell, it's the rate -- or speed -- at which money is actually spent in an economy. When an increase in the supply of money meets with an increase in velocity that exceeds the rate of the production of goods and services, then we have rising inflation.

If the Fed is printing money and all it is doing is forcing interest rates down, as it sits on banks' balance sheets, and those lower interest rates are not inspiring a rise in economic activity (resulting in increased velocity of money) -- which they haven't been (as much as you might think) of late -- sure, you get higher stock prices, while, among other things, companies borrow at cheap rates to buy back their shares: The knowledge of which inspires traders to buy stocks indiscriminately, exacerbating the bubble.

Now, all that said, while the Fed, and many on Wall Street, who reference PCE, tell us that there's simply no inflation, that's simply wrong. 

The Fed uses Personal Consumption Expenditures (PCE) as their measure of inflation (currently 1.5%), which always runs notably cooler than CPI (currently 2.3%). I suspect that a big part of the reason is that CPI weights housing costs twice as much as does PCE. Another popular criticism of PCE is that it captures medicare reimbursement rates to health care providers (while CPI doesn't), which of course are not what consumers pay, and they've declined markedly over the past few years. 

So, if you go with CPI, at 2.3%, clearly inflation is higher than the Fed is discounting. However, given all the money printing, that doesn't seem high enough, does it? 

Now we're back to the velocity of money, it's been dropping like a rock the past few years.

Here's the graph that measures it (since 2000):

That explains it...  and it's not a great look in terms of the overall health of the economy...

As for what gives the Fed the right to do that, that would be the Federal Reserve Act of 1913.