I’m definitely oversimplifying this but I’m curious if I’m missing a major input to inflation and if not then are inflation fears generally overhyped and investments like TIPS overbought? Everyone has probably seen this chart, the level of money in the economy, which increases from 800 Billion to about 2,600 Billion in just the past 3 years. This led me to believe that massive inflation was on its way once the velocity of money started to pick up. However, I came across this chart recently showing the historical trend of bank reserves and I was shocked to see that the historical levels were so low, but also that the increase was about 1,800 Billion….nearly the exact same amount of money being pumped into the economy. Shouldn’t these reserves offset the increase in the monetary base, and since they are just sitting in a vault wouldn’t this lead to practically no inflation? Also since reserve levels will have to rise over the next decade to satisfy Basel III requirements won’t the rising level of the velocity of money be offset somewhat by the increasing reserves? I must be missing a major factor in this equation…

Well, the increase in reserves should be approximately the same amount as the increase in the money supply (minus some slippage for money kept around as currency that never gets deposited in a bank). M2 should increase by the change in base * the money multiplier. But this depends on the banks lending to other organizations, who then use the money to pay for stuff and then deposit it in another bank. What seems to be going on now, is that banks take money from the Fed, buy US Treasurys with it, stick the long term Treasurys in their reserve account, and collect the interest on it. So the money doesn’t circulate. With the money equation, the Econ 101 relationship between money supply and inflation that everyone is assuming will happen depends on the assumption that money velocity is constant, and that real GDP is constant, neither of which are true. The velocity charts show that money velocity has declined substantially and has not really ticked upwards yet. My sense is that this is primarily because of deleveraging and the fact that banks are only starting to lend. Inflation could be in the cards a few years down the line. It really depends on how quicklky we think that money velocity will recover if the Fed starts to raise short term rates and the yield curve starts to flatten. In that situation, banks will start to lend more because the spread on “borrow Fed, lend to UST” will narrow. Velocity should increase, because banks will look to commercial lending for better yields. If the Fed does not contract the balance sheet to compensate (politically difficult to do, I suspect), then inflation is a real possibility. I suspect that the Fed will allow a higher target rate of inflation over the long term, perhaps more like 4% or even 5%. I don’t think we’re likely to see 10%+ inflation unless the squabbling in Congress really spooks the bond market, in which case hyper-stagflation is a very real possibility.

Inflation is already here, everywhere in fact outside of housing. Even though commodities have come down a bit recently, you’re still paying significantly more for energy, food, clothing, health care, and education (just to name a few) than you were a year ago. You’ve heard the CEOs of P&G and WalMart both warn consumers of much higher prices by the end of the year. You don’t need to spend too much time looking at money supply and velocity. Inflation is happening all around you. So what to buy? If you think stagflation is a possible outcome, buy TIPS. They’ll do exceedingly well. However, if the economy picks up along with rising prices TIPS won’t do as well since you “should” expect rates to start creeping up as well. People forget TIPS are still bonds. In that case, buy commodities. Or, just be lazy and buy gold and silver. They work in either scenario.