Understand that inflation is not going away anytime soon and the United States will probably experience an economic decline when inflation starts to fall. Business owners have become accustomed to deflation driven by enormous increases in productivity and cheap imports from China and other parts of Asia. However, the economic environment has changed and this means that business owners need to do their homework now to prepare for the long haul.

This is one of the most obvious cases of demand-push inflation. Suppliers are facing problems with the supply chain because the rebound in demand has been so strong and swift. The main driver, practically the unitary driver, has been the increase in money supply to support government spending in response to the pandemic.

There have been other sources of inflationary pressure, such as the Biden administration’s decision to throttle oil exploration and drilling, but those are minor secondary issues in relation to the enormous increase in the money supply as measured by M2.

The Quantity Theory of Money provides direct insight into our current inflationary challenges. The theory simply states:

(Goods that We Make and Buy) x Prices = Money Supply x Velocity of Money or

Gross Domestic Product = Money Supply x Velocity of Money and finally

Velocity of Money = GDP/Money Supply (M2)

The Federal Reserve, most prominently the Federal Reserve of St. Louis, divides the Gross Domestic Product by the Money Supply as measured by M2 to derive the Velocity of Money. The theory (and formula) is somewhat imprecise because of the changing nature of the Velocity of Money. There are three behaviors to note in this chart: the direct relationship between M2 and GDP, the enormous, increase in M2 since 2020, and the sudden drop in the Velocity of Money in 2020.

While the U.S. Federal Reserve just stated that it plans to increase interest rates and reduce its balance sheet, this will take time. In fact, the inflation that we are experiencing now is related to money supply growth in the first quarter of 2021.

The wild card in the Theory is the Velocity of Money. Velocity dropped to almost 1 during the pandemic as people held onto their money during that time of uncertainty. If velocity rebounds to pre-pandemic levels, which it probably will, we will see further upward pressure on economic growth and higher inflation even though the Federal Reserve steps firmly on the brakes.

The steady decline from 2005 on has had economists confused and is the main reason that the United States did not experience inflation even though the growth in M2 has been strong during that period. However, one thing is clear – the United States has never seen the increase in M2 (or any other monetary measure) and the inflationary pressures are uncertain.

*Beginning May 2020, M2 consists of M1 plus (1) small-denomination time deposits (time deposits in amounts of less than $100,000) less IRA and Keogh balances at depository institutions; and (2) balances in retail MMFs less IRA and Keogh balances at MMFs. Seasonally adjusted M2 is constructed by summing savings deposits (before May 2020), small-denomination time deposits, and retail MMFs, each seasonally adjusted separately, and adding this result to seasonally adjusted M1.

https://fred.stlouisfed.org/series/WM2NS