This Key Metric Could Be Holding Gold Prices in Check

When discussing inflation, money supply is often the focus. But there are actually two distinct monetary components that can influence inflation: changes in money supply, and the velocity of money, which is the average rate at which money changes hands in a given time period.

While the media has focused on the former, the latter has been largely ignored. This incomplete picture of monetary effects has left the public scratching their heads as to why inflation predicted at the hands of money growth has failed to materialize.

Here we will discuss, as simply as possible, the reason velocity matters, how it effects inflation in the short run, and finally, how this key metric will impact the price of gold and silver.

Velocity is important because, in short, economists believe increases in money supply (M) and velocity (V) have an impact on price (P) and output (Y) in an economy. This is represented by MV=PY.

Recently money supply has been increasing.

But over that same time, velocity has been falling, now down to record low levels.

So, what happens if money supply and velocity offset each other in the short run?

The Cleveland Federal Reserve recently released a report on Prices from a Monetary Perspective, which applied this framework to the U.S. GDP deflator -- a very broad price measure. The GDP deflator rose 1.3% on average during the first three quarters of 2013. This average price change consisted of a 4.3% increase in excess money growth and a 3% decline in velocity. 

The velocity of money often falls during recessions, or shortly thereafter, and its decline can persist for a long time after an economic recovery has taken hold. This is certainly true today. Since the onset of the Great Recession in 2007, the velocity of money in the United States has fallen sharply, at an annual average rate of 3.1%. This decline has offset average annual excess money growth of 4.9%, resulting in an average annual increase in the GDP deflator of 1.8%.

So, how does this relate to gold and silver?

In short, inflation has a direct effect on gold and silver pricing. If high rates of inflation threaten to to render paper currency less valuable, people often turn to hard currency like gold or silver as a store of wealth and potentially an investment. Given the finite nature of these commodities, prices naturally spike as a result of this increased demand. Sometimes even the expectation of inflation can move them higher, as it did from 2009-2011.

Gold is best represented through the SPDR Gold Trust ETF (NYSEMKT: GLD  ) , which is the largest physically backed gold ETF on the market. Since the failed realization of inflation that many expected, this ETF has been on a steady decline for the last two years, with little reason to abate at the hands of inflation. The iShares Silver Trust (NYSEMKT: SLV  ) has behaved in a similar fashion, peaking in 2011 and suffering a consistent decline since.

But perhaps the greatest pain has been reserved for the miners. When poor macroeconomic conditions hit, sometimes the businesses operating in that sector can fare even worse. As price declines hit a commodity, those same numeric declines often hit the profit margins, translating into even larger percentage decreases in terms of earnings. The Market Vectors Gold Miners ETF (NYSEMKT: GDX  )  is composed of global gold miners of varying market caps and has suffered the greatest percentage declines of the three discussed, down approximately 60% from its 2011 peak.

However, those same factors that made the mining sector so volatile going down could also lead to the greatest returns if gold begins climbing. But what exactly will lead to golds return?

The payoff
We all know consumer spending is key to the economy, composing a vast majority of GDP. However, what is almost as important is how fast that consumer turns over the dollars they earn, especially in an economy introducing copious amounts of money supply. While declining velocity has mitigated much of the predicted inflation, this likely won't persist forever. As velocity levels begin to recover, following the traditional business cycle model, look for gold and silver to begin picking up pace again, but this time with fundamentals firmly in their favor.

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