Across the developed world, central bank officials continue to reassure the public that the global spike in inflation over the past nine months is transitory and that inflation should return to pre-pandemic rates sometime in 2022.
Simply put, inflation occurs when the demand for goods and services exceeds the capacity of the economy to meet that demand at existing price levels. And demand remains a function of the total money supply and the rate the money supply “turns over”—a phenomenon economists call the “velocity of money.” To illustrate the concept, if the total money supply equals $100 and total spending equals $200, the money supply is said to turn over twice. If the same $100 was associated with $100 of spending, the velocity of money would equal one.
Within this framework, a slowdown in the growth of the money supply engineered by the central bank (for example, when the Bank of Canada ends quantitative easing) will slow the growth of overall demand (other things constant) and thereby reduce the rate of inflation. However, if the velocity of money increases, it could offset the impact of tighter monetary policy on inflation. Arguably, a dramatic decline in the velocity of money has helped maintain relatively low rates of inflation over the past three decades. By way of illustration, the velocity of money in the United States in the first half of 2021 was about half the average value over the 1991-2000 period.
The decline in the velocity of money partly reflects relatively low interest rates over the past few decades. When interest rates are relatively low, households and businesses are more willing to hold cash balances in their chequing and savings accounts. The velocity of money also reflects inflation expectations—if inflation is expected to remain subdued, as it has been over recent decades, households and businesses have weaker incentives to spend their savings to get ahead of expected rising prices.
Given the likelihood of rising real interest rates as central banks reverse their quantitative easing programs, and the growing potential for households and businesses to anticipate faster inflation given the recent acceleration of inflation, the velocity of money may increase substantially going forward. If it returns to anything close to its average value over the 1991-2000 period, aggregate demand for goods and services will increase dramatically, even if the total money supply does not grow at all.
Based on this scenario, all segments of the Canadian economy may soon face much higher interest rates than in the recent past if the fight against inflation is left largely to monetary policy. In this regard, policymakers should, among other things, improve the environment for business investment to help improve the supply side of the economy.