Do Low Interest Rates Cause Higher Velocity?

I recently wrote a post on booms and busts and interest rates.  I received the following comment/ questions from this post:

“Assume that we haven’t seen the level of inflation that one would expect given the tripling of the monetary base since 2007.  Further, assume that, in large part, the reason for that is a lack of velocity.  If we assume both of these things, how are they squared with the argument that in a artificially created low interest environment, people tend to spend rather than save?  If people are spending, that’s velocity, right?”

Let’s take the first two sentences first.  I assume that the commenter’s use of the term “inflation” is referring to price inflation.  We don’t really have to assume that we haven’t seen significant price inflation after a tripling of the monetary base.  This is in fact what has happened.

Secondly, we don’t have to assume that velocity is a large reason for this.  If there is a huge increase in the supply of money and it hasn’t translated into significantly higher prices, then there must be a higher demand for money (lower velocity).  The other major reason, which really goes along with a higher demand for money, is that bank reserves have increased dramatically.

So with everything going on, we would expect to see higher velocity, meaning money changing hands faster.  This would mean more consumer spending.  It would lead to higher prices.

But there is an assumption in the comments that I don’t completely agree with.  The commenter used the phrase “artificially created low interest rate environment”.  But we cannot really know how much is artificial and how much is not.  While the Fed has been buying a lot in the way of government debt and mortgage-backed securities, and this has certainly contributed to lower interest rates, I’m not so sure we wouldn’t have seen low interest rates anyway, given the previous mess created by the Fed.

We are in an environment of fear and we mostly have been for almost 5 years now.  The general public is scared of recession and unemployment.  People are not generally as scared about price inflation.  In some ways, this can be a self-fulfilling prophecy by the general public.

In a recessionary environment, it is common to see low velocity.  Cash is usually king in a recession.  This means there is a high demand for money.  People are afraid of losing their jobs and they try to build cash and pay down debt.  This is not to say that things can’t change quickly if enough money floods the system.

Right now, real interest rates (rates adjusted for inflation) are negative.  But they are not negative by a lot.  We still have relatively low price inflation, at least as stated by the government’s CPI numbers.  If price inflation were at 10% and interest rates were still really low, then we could be more certain that they are being kept down artificially.  Such a scenario would also likely result in much more spending (higher velocity), even in recessionary conditions.  We saw this happen in the late 1970’s.

I think we will likely see much higher velocity, and hence higher price inflation, in the future, assuming that the Fed keeps creating new money out of thin air at a rapid rate.  We have to get to a point where the general public is more fearful of a depreciating currency than it is of a recession.  At that point, we can expect to see significantly higher prices.  We can also expect another huge run in the gold price.

2 thoughts on “Do Low Interest Rates Cause Higher Velocity?”

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