A chart of Chinese imports
A chart of the velocity of M2.
Normally, we expect money to flow in an economy in a circular fashion.
I.E. The farmer grows barley, ships it to the city, the horses eat it, provide work in the city, the factories in the city build stuff, the farmer buys it to grow more barley and round and round it goes. The velocity of
money capture this cycle.
But, Japan first the China have thrown a wrench or an escape chute into this cycle. Normally if we increase M2 we get an increase in inflation, but we have been increasing M2 for a long time.
I do not recall who said it, but I do recall the statement. “We are exporting inflation to China.” Another way to say it is “China labor is absorbing our inflation due low labor costs” This was mostly true. However, I believe it is not the whole story. China also absorbed and buried a lot of our M2 and in so doing killed the Velocity of Money inside our economy. In other words the money even if it could have been captured in the Velocity metric used at the Fed, simply quit flowing in a cycle and ended up in giant ghost cities and massive public works projects in China and as part of the One Belt One Road.
Now that is over, the Velocity of Money is starting to pick up. If the late 1960’s and early 1970’s are an indication, it must pick
increase by 50 percent from where it is. As the Inflation Reduction Act along with the lessons from Covid and the Ukraine war are pulling a lot of the supply chains back to the United States and China is no longer pouring captured dollars in the concrete ghost cities (metaphors here, the actuality is much bigger) the Velocity of Money will increase and there is nothing that the FED can do about it. To control inflation the FED must pull the one lever it has, M2. M2 is very large for the size and speed of growth of the economy, so even a real decline in M2 will not stop inflation. It will take a dramatic and sustained decline in M2 to rein inflation.
I am not sure that the Fractional Reserve banking system can take that. This is a sea change that I have not lived through since I got my first paycheck in 1975. In fact, I am not sure there is any historical equivalent anywhere in history.
So I have made two assumptions, either or both could be wrong.
The Velocity of Money and M2 have a mathematical relationship that outputs inflation. The decline in the Velocity of Money has created negative inflation pressures for the last 20 years while M2 has grown at rates well above the growth rate of the economy (U.S. or World)
The Velocity of Money is not properly captured because the money left the normal flows and when to China with a different sort of economy and the Velocity actually did slow because the Chinese buried it in massive internal investments.
These could be wrong, in fact they probably are.
If anyone can delve in and show different money flows and their impacts I would be interested.