The path of US inflation depends in large part on the outlook for the velocity of money (M2).
The velocity of money is defined as GDP divided by the money supply, M2 in this case. In colloquial terms, it measures the number of times money turns in the economy every year. From 1960 until 1990, the velocity of money (M2) was broadly stable around 1.8 times per year.
This accelerated to 2.2 times during the Clinton administration, but began a long decline after 2000. Velocity stabilized a few times in the intervening years, but resumed its decline eventually.
From 2017 until the start of the pandemic, velocity appears to have stabilized around 1.45 turns per year.
Velocity collapsed with the pandemic, with the great slug of stimulus staying on the sidelines initially and thereby collapsing velocity. In the last year, however, velocity has begun to increase, and on current trends, might be expected to regain pre-pandemic levels by the second half of 2024.
Were this to occur, and were monetary policy neutral (that is, growing at the same pace as GDP), the we might expect a few pretty hot quarters of inflation in mid-2023, as high as 9% for a quarter or two. However, if the Fed continues to reduce M2 at the pace of the last five months, assuming no recession, inflation would come in around 6.5% per the model for the next few quarters, but return to normal levels by 2024.
Source: FRED M2V
Alternatively, the velocity of M2 could resume its long-term decline. In such an event, the US would be on the cusp of deflation of about 3.3% / year, almost 6% allowing for a continued reduction of the money supply (M2) at the pace of the last five months.
These are two highly polarized outcomes, one with an inflation surge and another promising a bout of brutal deflation, almost certainly accompanied by a stiff recession.
It’s difficult to know how to choose between these two eventualities, and I could make a case for either.
However, if we look to the precedent of the Spanish Flu of 1918, then a clear preference emerges. Deflation is on the horizon. The US suffered a short but sharp downturn known as the Depression of 1920/1921, that is, three years after the start of the flu. During this downturn, GDP is estimated to have fallen by 2.4 % to 6.9% and prices declined by 13% to 18%, depending on the study.
It would be comforting to think we could avoid the mistakes of history, but the cynic in me is inclined to think that we will prove no smarter than we were a century ago.