Tuesday, February 14, 2012

Increased Currency Has No Relationship to Increased CPI

When the Fed started its QE programs -- both 1 and 2 (and now possibly three) -- a common argument raised against the policy was it would lead to inflation.  However, the chart above shows that argument to be wrong on many levels.

Above is a chart of the YOY annual rate of change in M1's currency component and the YOY percentage change in CPI.  Basically, there is little to no correlation between the two numbers.  In fact, there are several instances where we see large YOY increases in M1 (twice in the 1980s, the early 1990s and early 2000s and coming out of the latest recession) where we see CPI's YOY increase drop.  The reason for this is simple: the Fed increases money supply in anticipation of a slowdown, when, coincidentally, there is lower pricing pressure in the economy, which leads to lower inflation.

Also of importance is velocity -- the speed at which money flows through the economy.  If the fed prints a lot of money but no one spends it, there can by definition be no inflation.   However, that is one for the next post.