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A possible short-term inflation risk [ClearOnMoney]
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A possible short-term inflation risk

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Commentary

A possible short-term inflation risk

23 Jan 2011 by Jim Fickett.

Historically, the velocity of money has been strongly correlated with short-term interest rates. This implies that if holders of US debt start to worry and require higher interest rates, the result might be inflation in the short term.

Most investors, including me, see inflation as a risk that is probably at least a few years away. John Hussman today makes an interesting argument that if worries about US debt were to push up short term interest rates, it might bring on inflation in relatively short order.

First two definitions:

  1. The monetary base is currency in circulation plus bank reserves at the Fed
  2. The velocity of money is nominal GDP divided by the monetary base

Given the second definition, it is just an identity to say that

(Monetary base) * (velocity of money) = (real GDP) * (price level)

The question Hussman addresses is, what happens in this identity if short-term interest rates rise? Hussman raises the issue that the monetary base might not shrink. I would go further and say that the monetary base would almost certainly not shrink – shrinking the monetary base would require the Fed to sell assets at depressed values, and the constant propaganda from the Fed and the Treasury to convince the public that the bank bailouts are not really costing anything strongly suggest that the Fed would be reluctant to sell assets at a loss. Hussman also shows that, historically, the velocity of money is correlated very strongly with short-term interest rates – higher rates are associated with higher velocity.

So the left hand side of the identity would probably increase. Going to the right hand side, a rise in rates would likely be associated with a decrease in real GDP, or at least not an increase, which would mean that the price level would have to rise. Hussman estimates that if the three month T-bill rate rose to 0.35%, it could imply a 14% increase in prices.

A significant caveat to this argument is that the historical correlation between short-term rates and velocity does not necessarily imply causation. Still, this is a plausible argument that a change in sentiment in the bond markets could cause inflation in relatively short order.