Recipe for Disaster: Why Velocity is Inflation’s Most Dangerous Ingredient

[Ed. Note: There’s a theory out that’s been going around probably for as long as QE has been going on, and it goes like this: The Fed has been paying interest on excess reserves that banks keep parked at the Fed. At some point, they’re gonna stop paying interest on those excess reserves. Then, wham! Hyperinflation. It’s Weimar, 1923 again. We asked Jim Rickards to explain what’s right or wrong about that scenario…his answer, below.]

First off, the reason the Fed is paying interest on excess reserves is to give the banks money to pay higher insurance premiums to the FDIC. Remember, Dodd-Frank raised the insurance premiums on the banks that they have to pay for their deposit insurance. That would have hurt bank earnings. So the Feds said, “Fine, we’ll just pay you on the excess reserves, take the money and pay your premiums.”

So this is just another game. This is just another shadow play where it’s basically a backdoor way of financing the FDIC premiums with printed money so the banks don’t actually have to bear the cost. That’s the reason they’re doing it.

But, beyond that, this notion that, if they stop paying the interest that, all of a sudden, the banks will say, “Well, we’ve got to make some money. We’ll go out and lend all this money,” I don’t agree with that at all. In fact, it’s not right.

To get inflation – and by the way, inflation is a danger. I’m not saying it’s not a danger. It’s a serious danger. But the dynamic is different than these theorists suppose.

Here’s the real problem: To have inflation, you need two things. You need money supply, but you need velocity. Velocity’s the turnover of money.

So, if I go out tonight, and I buy a drink at the bar, and I tip the bartender, and the bartender takes a taxicab home, and the taxicab driver puts some gas in his car, that money has a velocity of 3. You’ve got the bartender, the taxicab, and the gas station.

But, if I stay home and watch TV or buy gold and leave it in a vault, that money has a velocity of zero.

So the nominal GDP — the nominal gross value of all the goods and services in the US economy — is simply, how much money is there? What’s the velocity? It’s money supply times velocity. You need both to cause inflation. You need money supply times velocity to be greater than potential GDP, and the excess shows up in the form of inflation. So the Fed has taken the money supply to the moon. The velocity’s collapsing. That’s the problem.

So, now, what would cause inflation is not more or less money printing or payment of interest on excess reserves. What would cause inflation is the change in velocity, which is behavioral. It’s the change in the psychology. That’s what you have to look for, what the Fed actually calls inflationary expectations.

And so I like to say, if you want inflation, it’s like a ham-and-cheese sandwich. You need the ham and the cheese. Money-printing is the ham, and velocity is the cheese, and you need both to get the inflation.

So the thing to watch for is a change in inflationary expectations, a change in behavior. And that can happen very quickly, and that’s why inflation is so dangerous. It might not show up at all, and then, suddenly, it will come very quickly because it’s very, very difficult to change the behavior. But, once you do, it’s very difficult to change it back again. And that’s why inflation runs out of control.