The Rate of Inflation

Inflation, properly defined, is an increase in the amount of currency available in an economy. The increase in prices that follows is not inflation, but a consequence of inflation. However, the devil has a way of corrupting language so as to obscure what's really going on, and we are now almost always referring to increases in prices as inflation.

To remedy this confusion we can use the term "monetary inflation" to mean the expansion of the currency supply, and we can use the term "price inflation" for the increase in prices that follows.

A further point of confusion when it comes to inflation is that price inflation comes with a delay to monetary inflation. There's also an imbalance in how prices change. Some things go up in price sooner than other things, as pointed out by Richard Cantillon back in 17th century France.

With most people having a short time horizon when it comes to cause and effect, many pointed out with glee that the monetary inflation that took place in response to the virus scare back in 2021 didn't result in price inflation on ordinary goods. Tech stocks, crypto currencies and NFTs went ballistic, but products in supermarkets remained relatively unchanged.

Now that prices are going up in supermarkets, the same short sighted crowd refuse to see any connection with the monetary expansion that took place two years ago. Two years back in time is by many considered ancient history, and any connection between events today and back then is considered impossible.

Adding to the confusion, monetary inflation has in fact been negative over the last few months. There was more currency slushing around in the economy a year ago than today. Why then are prices in supermarkets going up?

This leads us to the final point of confusion when it comes to the relationship between monetary inflation and price inflation. Most people see the two as either directly linked or not linked at all. The idea being that the 50% increase in the currency supply that happened during the virus scare should have led to a 50% increase in prices. However, this has not happened so it's either not going to happen at all, or we are in for just a little more price inflation before all the monetary inflation has been fully absorbed. Either way, we're not going to see prices going up by more than 50% from 2021 levels.

The error here is the assumption that price inflation is dependent solely on the quantity of currency available in the economy. It isn't. It's dependent on both quantity of currency and the rate at which transactions happen. Price inflation can therefore go higher than monetary inflation.

Here's a simple calculation to illustrate this point: Imagine a currency rotating in the economy at one transaction per week. If this rate remains constant, and we increase the currency supply by 50%, we will see 50% increases in prices pretty much immediately.

This is the simplistic view that is assumed by those wondering why we haven't seen this effect. However, people were scared during the virus scare. They didn't keep up their rate of transactions. The currency supply went up by 50%, but the amount of currency used in everyday transactions remained pretty much unchanged. Instead of going into the economy, the extra currency was saved for later. The rate of transactions went down.

Now that the scare has subsided, currency saved has entered the economy, and we're seeing price inflation. But there's no reason to believe that prices will top off at a 50% increase because the rate of transactions may accelerate from here on out. Once people sense that currency is best spent as soon as possible, the rate of transactions go up.

Going back to our example, we can imagine our currency rotating in the economy at two transactions per week. At that rate, prices will by average go up by 100%.

This may in turn prompt people to get rid of their currency even quicker, and a situation may arise where currency is immediately exchanged for goods. The currency rotates at one transaction every day, and prices go up by an average of 700%.

Price inflation can get out of hand even without monetary inflation, and there's some evidence to suggest that this is about to happen. Search interest for gold is on the increase. People are looking for something other than currency for their savings. An increasing number of people are determined to keep as little currency as possible as savings. They plan to spend currency on gold rather than saving it in a bank account.

If this happens at a large enough scale, we'll be back on a de facto gold standard, with currency only used for transactions and not used as savings. Economic planning based on currency will no longer be possible because no-one will know what a currency buys a year or two into the future. Gold will have to serve that purpose. Contracts will have gold clauses in them. Gold will even be used directly in transactions, at which point central banks will have to either send interest rates on bank accounts soaring to lure people back to saving in currency, or link the currency directly to gold so that it can again be used for economic calculations.

Sovereign

By Heritage Auctions for image, Mary Gillick for coin - Newman Numismatic Portal, Public Domain, Link