January 26, 2022

The end of the bond purchases resulting in a significant decline in the growth of the monetary base. Looking at Figure 4, a reducing the balance expansion leads to a slower monetary base and M2 growth rate and all else the same a lower inflation rate. However, as we have already mentioned that is only half of the story. The Fed is forecasting of a 4% real GDP growth rate , hence all else the same, the real GDP growth rate will increase the demand for M2 by a corresponding amount. The Fed tapering suggests that the M2 less GDP growth is likely to be negative and in the high single digit in the near future. But these numbers alone are not enough to determine whether there is an excess demand for or supply of money. The wild card here is the velocity of money. Figure 7b presents some disturbing information, the real GDP growth rate is rising and the velocity rising, not a good combination. As long as the increase in the velocity of money does not exceed the real GDP less M2 growth by more than 2%, the inflation rate will converge to the 2% target rate or below. This brings us to the issue of whether the velocity of money is likely to rise and how much? The velocity of M2 exhibits a downward secular trend with temporary deviations from the downward trend coinciding with the Dot.Com , the Financial Crisis, and the Pandemic downdrafts. In time, the velocity returns to its trend line. It takes one to two years for the velocity to growth rate to return to trend. The recent data indicates that the M2 velocity has begun to reverse the Pandemic decline. Whether the inflation rate rises, or falls depends on whether the velocity of M2 exceeds the growth of M2 less the real GDP growth rate. Our calculations suggest that as long as the velocity of M2 increases in the single digit range, we expect the inflation rate to converge to the target range. An increase in the velocity of money in the double-digit rate would make us reassess our inflation outlook.

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