The Fed Really Needs to Look at This Chart: Deflation Ahead

Rule number one – when you’re in a hole, stop digging. If the Fed is serious about trying to prevent price deflation, it should STOP printing money.

It’s been a well-worn policy response from the Federal Reserve for many years now. If the economy stumbles, just print more money – quod erat demonstrandum (QED), the economy should recover. Printing vast sums of money should certainly ward off any threat of price deflation. So goes the thinking at the Eccles Building in Washington D.C, where the Fed is headquartered. Could that thinking be wrong?

The chart below shows the velocity of the M2 money stock versus Core Consumer Price Index (CPI) on an annual percentage change basis. M2 Velocity is a ratio, calculated by dividing the nominal Gross Domestic Product by the M2 Money Stock. As more money is printed relative to the size of the economy, M2 Velocity declines. The chart shows that the annualized change in M2 Velocity has collapsed, as not only has M2 Money Stock expanded, but the economy has contracted.

Now look at its relationship with Core CPI, the annualized change in consumer prices excluding food and energy. Over the past 20 years there has been a distinct relationship, with the change in M2 Velocity leading Core CPI by around 7 quarters. Therefore, if this relationship holds, we must anticipate a huge drop in the year-on-year rate in Core CPI over the next 18 months or so.

What this evidence suggests is that, contrary to conventional thinking, not only does money printing not lead to increasing price inflation, it can actually lead to price disinflation and possibly deflation. Perhaps QED in this context should mean, Quantitative Easing equals Deflation.

Price Deflation Ahead