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Commentary & Analysis
The Grand Non Sequitur: The Fed, Monetary Velocity, and Danger of Asymmetrical Wealth Effect
- The Fed must pump money for the economy to improve.
- The economy is improving.
- Therefore, it is right for the Fed to pump money.
The market clearing route at the “macro” level is no longer even considered as a possible policy alternative any longer. The misallocation of capital into non-productive segments i.e. stock and housing bubbles globally is growing vast. If we expect cash flow from the real economy to support the “E” side of P/E ratios in stock, and service the massively growing debt burden almost everywhere, then it seems either growth must start to explode upward or stock and lower quality bond prices might start exploding downward. The Fed is the savior, but the Fed is failing its flock. The only question is when will the flock flee?
Everyone (accept those who trust the market process) knows only Keynesian responses are responsible in times of crisis. Allowing for a market clearing solution (Austrian or at least quasi-free market approach) would have meant a tip into the abyss, goes the consensus among most academics and bureaucrats (exactly the type of people who dominates our illustrious Federal Reserve Open Market Committee; at least Stanley Fischer (Mohammed El-Erian’s former boss at the IMF) is a closer link to the market; even though that link seems quite corrupted. I say corrupted assuming you don’t like having US taxpayer money funneled through the IMF and World Bank to help Fischer’s buddies control vast sectors of wealth in massively subsidized fashion).
Why is it most of the academics and bureaucrats would likely agree markets must clear on a “micro” level in order to maximize economic efficiency; but argue strenuously against such a remedy on a “macro” level? My short answer: Crony capitalism and political power over income redistribution…
Monetary velocity continues to plunge as Fed supporters declare victory. To me, it is the clearest indicator of abject policy failure on the part of the Fed. Falling velocity connotes deflationary pressures and stagnant growth, and possibly many other things such as fear and demand for savings.
Some place little faith in velocity as an indicator of anything. It is one piece of the puzzle and can be quite volatile and shouldn’t be used in isolation as the Holy Grail indicator. But someone as important as Irving Fisher, an American economist who did the groundbreaking work on the link between debt and deflation believed monetary velocity was at the heart of capitalism.
One important thing to keep in mind, which helps you understand why the Fed, by effectively pushing rates to zero, has ensconced itself in a very tight box:
Monetary Velocity is correlated with the level short interest rates.
You can see that correlation in the brilliant chart below which comes from GaveKal economic advisers:
Here is GaveKal’s summary…
The relationship seems obvious enough, even for something as heavily manipulated as the 3 months UST bills. Interest rates and velocity are correlated, and velocity has never risen without interest rates doing so as well - except once, in 1994, when the Fed, artificially prevented short rates from rising, worried as it was by the S&L crisis (the beginning of the Greenspan put and perhaps the source of the troubles we find ourselves in today?).
This bodes the question: since the Fed has been guaranteeing no changes in rates for years to come, and since we have witnessed falling velocity every time we had stability in interest rates, then does this mean that velocity will keep falling as long as interest rates remain at 0%? If so, how can we not expect a deflationary scenario with stagnating growth and/or collapsing inflation?
GaveKal goes on to discuss velocity as a variable, albeit the important one, within the context of Irving Fisher’s important equation:
MV = PQ
M = Quantity of money
V = Velocity of money
P = Price Index
Q = Quantity produced in an economy
…thus PQ = Nominal GDP
I don’t want to get all wrapped up in this discussion of variables. But you can see there are a lot of moving parts closely connected and inter-related (“economic science,” it is to laugh!).
But suffice it to say, GaveKal’s most likely scenario corresponds with my favorite—rising real yields slamming debtors and adding more deflationary pressure in a self-feeding manner:
Nominal rates down, but real rates up: This is the central scenario of Irving Fisher’s Debt Deflation Theory of Great Depressions; the scenario which prevailed in the 1930s across most of the Western World, i.e., debt deflation and secondary depression. When such a scenario unfolds, the only assets to own are government bonds and the equity of the least levered, most productive, producers. It is in this scenario that velocity becomes a really independent variable and where any ‘over indebtedness’ starts to hurt.
It is the “real rate” that does the damage to debtors, i.e. [Real rates = Nominal Rates – Inflation], thus as inflation declines and/or outright deflation takes hold, real rates rise. And when real rates rise faster than economic growth there is no place to hide.
This is the concern now enveloping the European Central Bank’s future policy decisions. And the euro took a hit on the expectation ECB rates will go lower. But I’m not sure if zero interest rates will help European growth, or counter deflationary pressures, any better than they have in the US? In fact, given the level of periphery debt and current underpricing of risk reflected in Eurozone bond markets, lower interest rates could make things a lot worse.
LONDON, May 9 (Reuters) - Italian and Spanish borrowing costs hit record lows on Friday in a broad-based rally in lower-rated euro zone bonds after the European Central Bank signaled it could deliver fresh monetary stimulus next month.
Lower official rates don’t seem to be the problem facing the Eurozone. The structural flaws and forced austerity seems the trouble, not liquidity.
Obviously the bigger countries have more debt issuance. But the concern here is France and Italy don’t seem to be improving as much as the other periphery countries. Those two alone represent 47% of total eurozone government debt.
So, we have a Fed and US Federal government policy on the same track; neither wants to allow the market to clear to any significant degree. And many markets must deflate in the Eurozone as countries; as the currency regime allows not pressure valve. Plus everyone’s favorite demand source—China—is struggling to keep a lid on rising debt and risks of shadow banking’s non-productive investment and outright speculation. Rising global debt and seemingly declining cash flow to cover debt-service. Nuts.
The Fed for some reason will argue its policy of using QE to boost financial assets makes sense because of the “wealth effect.” But recent research on this topic shows there is little or no wealth effect created by the boost in stocks or housing. [See the latest issue from Hoisington Research for more on this topic.]
But I keep think there is the possibility of a powerful negative wealth effect should the stock market break. George Soros said in his book, “Alchemy of Finance,” that the stock market was the world’s largest repository of collateral value. If so, collateral values have soared since 2008; but the wealth effect the Fed was expecting never really materialized. If collateral values soared, why are small businesses having such a tough time in this “recovery?” I think the stage is set for an asymmetrical wealth effect to the downside as collateral values could get hammered, i.e. those with the capital starting running for the exits (I always wanted to use the word “asymmetrical,” as I thought it would make me sound so smart, like those real research guys at the big banks. It didn’t).
It all tells me one thing; the “New Abnormal” will likely be with us for years to come.
I leave you with a brilliant discussion on income inequality and equality by Milton Friedman and Thomas Sowell; two of my all-time favorites.
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Happy Friday and have a great weekend.
Black Swan Capital