DOES MONEY VELOCITY TELL US ANYTHING ABOUT INFLATION AND THE NEED TO TIGHTEN?

As we prepare for an announcement soon about the future course of monetary policy in the United States, some comments about money velocity and inflation may be useful.  If I heard correctly, then Steve Liesman of CNBC television reported yesterday (Monday) morning that more than forty per cent of survey respondents think that the Federal Open Market Committee (FOMC) of the Federal Reserve Bank may not only taper more (meaning further slow down the Fed's purchases of U.S. Treasury longer-term debt) soon, but the FOMC may also pursue tighter monetary policy, by raising the target for the federal funds rate, or the bank-to-bank overnight lending rate.  The Fed would change its purchases and/or sales of U.S. Treasury T-bills with a short term to maturity as needed to achieve its goal for the federal funds rate.  A monetary policy tightening would result in less aggregate demand in the economy, all other things  equal.  If the FOMC reduces the level of aggregate demand or at least the growth rate of aggregate demand if not the level of aggregate demand, then prices would not rise as quickly.

Presently, is it necessary for the Fed to tighten?  While others may not agree, at least in my view, the answer to the question is unclear.  The M1 and M2 money supply levels have increased quite rapidly since the start of the Great Recession, and even more rapidly since the start of the COVID-19-related economic collapse.  With unemployment rates in the U.S. now relatively low and real GDP having resumed growth, it is understandable that people are concerned about controlling inflation pressure as inflation has increased while (a) aggregate demand growth has increased and (b) supply-side issues are helping to increase costs.

However, as I pointed out in my previous blog entry (https://harrisonhartman.blogspot.com/2021/12/interest-rates-expected-inflation-and.html), financial markets may be signaling only a relatively modest increase in expected inflation.  Further, frequent CNBC guest Art Cashin may point out that the velocities of both the M1 and M2 money supply levels in the U.S. may still be falling (although he might emphasize M2 velocity).  In his view, that could indicate little pressure for inflation.  I think he said on CNBC more than once in the past that spending and lending lead to inflation, but simply holding money does not.  (My memory is that my book It's Velocity, Stupid! (short title) also questioned whether inflation would rise without an increase in money velocity.)  Clearly, an increase in spending could increase inflation, the percentage growth rate of the price level, or at least lead to a one time  increase in the price level.  Greater spending all other things equal results in an increase in aggregate demand.  In a simple aggregate supply/aggregate demand (AS/AD) framework, the equilibrium price variable is higher when the AD function shifts right.  A possible topic for future discussion and/or research could be whether an increase in loans granted without an increase in spending leads to inflation.

I do not know if Art Cashin still feels the same as he did about money velocity and inflation.  Regardless, if his previous if not current analysis about money velocity is accurate, then the FOMC would risk spurring a nearly pointless if not completely pointless recession by shifting the AD function left by tightening without a level of inflation pressure that many would think would warrant such a policy shift so soon.  If I heard frequent CNBC guest Josh Brown today (Tuesday) on that network correctly, he thinks that inflation in the U.S. is at its (local) peak now.  If that turns out to be correct, then there may be little or no need for tightening at the present.  More about the possible need for continued expansionary fiscal policy in the U.S. (and likely also other countries) will probably be in my forthcoming book.  We will probably get another glimpse at the FOMC plans starting tomorrow.

(Added December 17, 2021:  Tapering by the Federal Reserve Bank could also include the Fed buying fewer non-Treasury securities.)