While I often focus on the money supply as measured by the adjusted monetary base, as well as the excess reserves held by commercial banks, it is important not to ignore the issue of velocity.  Velocity is the demand for money.  If velocity is high, then it means the demand for money is low.  High velocity means that money is changing hands quickly.

Low velocity is the opposite.  Low velocity means that people are trying to hold on to their money.  They are not spending as much.  This has the effect of lowering prices, or at least keeping them lower than they otherwise would have been.

Velocity is very difficult to measure, but I believe we have been in a low velocity environment ever since the fall of 2008.  Even though the Fed has quadrupled the monetary base, consumer price inflation has not reflected this.  A big reason for this is due to the fact that most of this additional new money has gone into excess reserves.  The new money is not multiplying via the fractional reserve lending process as it normally would have in the past.  But I also believe that the high demand for money (low velocity) is the other major factor keeping price inflation in check.

It is certainly logical that velocity would be low, despite the massive monetary inflation by the Fed.  People are afraid of the current economy.  After the boom times ended about 5 years ago, people have been getting out of debt (aside from the huge number of foreclosures), or at least trying to pay down debt.  Unemployment is high and wages have been stagnant at best.  It is reasonable to expect people to cut back on consumer purchases in favor of setting aside some emergency cash.

We must also remember that things can change quickly.  Velocity is as much about perception as anything.  If people perceive that their money will be worth significantly less in the future, then they will be more apt to spend it, even if it is on something that they don’t need right away.

If your car is getting older and you think car prices will be 10% higher next year than they are right now, then you may decide to go ahead and buy your new car now instead of waiting.  This is rational thinking.

I expect the gold price will be a good measure of what is happening with velocity.  If the economy is headed back into a recession (if it ever got out of one), then the gold price could drop further from where it is now.  Velocity will stay low or go even lower.

On the other hand, if we see another artificial boom, propped up with more “quantitative easing” from the Fed, then we could easily see velocity go higher.  We can also expect a much higher gold price.  The stock market is already indicating that this is a possibility, but we can’t be absolutely sure.

The interesting thing with velocity is that it feeds on itself.  If people expect higher prices next year, then they will spend more now for consumer goods.  This in turn drives up prices, fueling the fear of rising prices.  This is really what started to happen in the late 1970’s, until Paul Volcker and the Fed stepped on the monetary brakes and stopped inflating.  Interest rates skyrocketed and the economy went through a deep recessionary period.  However, it also cleared out most of the previous malinvestment and allowed resources to be reallocated to better uses (according to consumer demand).  This allowed for some genuine prosperity to follow.

So while Fed policy will be important going forward, we must consider how people are reacting to Fed policy and what their expectations are for the future.  The demand for money will play a major factor in future price inflation, as well as the overall state of the economy.