March 21, 2010

PT ≠ MV?

Posted by Izabella Kaminska on Mar 19 14:17.

Oh dear.  Fed tightening talk abounds and yet there’s still no evidence that all that extra liquidity has got into the system.

Note the latest M-1 multiplier data from the Federal Reserve, which continues to show a deterioration in the velocity of money (H/T Themis Trading’s Joe Saluzzi):

Excess reserves at depository institutions, meanwhile, are continuing to grow:

And if you look to the commercial paper market for an indication of how much money is actually making its way into the real economy, the data are hardly reassuring:

So what’s wrong with Irving Fisher’s famous MV = PT equation? Why has throwing money at the problem not affected the relationship between money and income in the equation the way it supposedly should?

Standard Chartered have pondered the issue this week (a subject of which they are somewhat fond, we note). As they commented:

As such, a boost in money supply would lead immediately and directly to an increase in price – or inflation. From this premise sprang Milton Friedman‟s famous dictum; “Inflation is always and everywhere a monetary phenomenon.”

Their assumption then is that there must be a misunderstanding about the velocity component – something most economists assume remains constant.  As the Standard Chartered team note, ‘V’ is most likely dependent on one key thing:

To answer the question of why monetary velocity is not constant, we have to determine why it rises in the first place. The answer is both logical and straightforward: financial innovation. As a national financial system evolves, it is logical to assume that its monetary velocity – the number of times the stock of money changes hands – should increase until the economy becomes „efficient‟ in the monetary sense. Thereafter, it may moderate or decline by small increments depending on the economic cycle, but should remain relatively stable.

There are, however, periodic exceptions to this „rule‟ of relative stability: booms and busts. If inflation is always a monetary phenomenon, then the same can be said for booms and busts, which are, after all, a function of asset-market inflation.

Yet an important component of financial booms is financial innovation; subprime mortgages and related financial structures are a recent example. Financial innovation should increase monetary velocity.

Financial booms see an increase not only in money supply, but also in the use of that supply. The result should be – and was – massive asset-market inflation. Eventually, boom turns to bust. This also has a monetary response. It was no coincidence that the crisis was most severe where there was the most financial innovation – the US and Europe. As such, it should also be no surprise that monetary velocity fell the hardest in those markets.

By that argument, it makes perfect sense for the central banks to begin removing extra liquidity operations from the market at this stage, say the analysts. Financial innovation, after all, has been momentarily suspended, while velocity of money has stabilised, even if it hasn’t actually improved.

Overall, there is less of a need for ‘M’ (money supply) to remain so high. Or as they put it:

Indeed, „M‟ has to be reduced in order to avoid a spike in „P.

But that doesn’t mean markets should interpret the removal of liquidity operations as central bank ‘tightening’. Velocity has stabilised, not increased.

This is monetary policy normalisation, if anything, because ‘V’ is at historically low levels in the wake of the credit crisis and “is  likely to remain subdued for the foreseeable future”, according to the analysts.

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