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Modern Monetary Insanity, Part 2
What Was The Fed Thinking?
In the first part of this discussion, I explored the historical trends in Federal Reserve monetary policy from 1997 through 2019. That background sets the stage for apprehending where the Federal Reserve is today—between a proverbial monetary rock and an interest rate hard place.
To summarize Part 1, through a combination of extremely low interest rates and large-scale asset purchases known as “quantitative easing”, the Federal Reserve, in an effort to prod (consumer price) inflation up to a level of around 2% based on the official Consumer Price Index. Through a combination of asset price inflation and a general decline in money velocity, the Fed’s efforts in that regard were largely a failure—at least in terms of policy objective.
The markets, of course, loved the easy money conditions and became quite addicted to a steady influx of newly created money.
Thus the Fed was, even in 2019, in a clear policy trap of its own making. It could not even then shrink the greatly expanded money supply or raise interest rates without quite literally crashing financial markets. At the same time, if the money supply were not reduced, and interest rates were not raised at least a little, a reversal of declining money velocity would invariably trigger not just inflation, but potentially hyperinflation to exceed the levels last experienced in the 1970s “stagflation” crisis.
Then 2020 happened.
2020: Over The Cliff
2020 will go down in history as “the year that everything changed.” Literally.
Driven by the serial lunacies of the COVID-19 Pandemic Panic (about which I have written at some length), there were several shocks to the economic system that year.
Virtually overnight, the Federal Reserve expanded the M1 money supply by multiple orders of magnitude. The degree of expansion can be seen by the comparison to the much smaller expansions of Japan’s money supply and the money supply of the Euro zone.
If there was need to drain liquidity and shrink the money supply in 2018, that need is many times more urgent today.
Yet because money velocity has dropped to virtually nothing, the inflation response to this increase in money has been fairly muted, rising to “only” 8.6% year-on-year.
Think on that: consumer price inflation is at 8.6%, the highest in decades, and that is after the money supply was increased by over 1000%! By comparison, inflation during the 2008 recession peaked at 5.6%, largely before the magic money printing press was started.
How low is money velocity currently? To put it bluntly, there isn’t any.
The Fed’s data sets on money velocity, which go back to 1960, do not show a single period where money velocity—particularly for the M1 money supply gauge—has ever been this low.
If money supply is a measure of economic activity and expansion, then the US economy is currently comatose.
Yet despite money velocity falling off a cliff in response to the COVID-19 Pandemic Panic, inflation undeniably began rising immediately thereafter.
How does this happen? One paradoxical answer: it’s not “inflation”.
Quantity Theory Of Money
How could inflation not be “inflation”? To understand what I mean by this, we must first briefly cover the Quantity Theory Of Money.
Central to monetarism is the "quantity theory of money," which monetarists adopted from earlier economic theories and integrated into the general Keynesian framework of macroeconomics. The quantity theory of money can be summarized in the equation of exchange, formulated by John Stuart Mill, which states that the money supply, multiplied by the rate at which money is spent per year, equals the nominal expenditures in the economy. The formula is given as:
V=velocity (rate at which money changes hands)
P=average price of a good or service
Q=quantity of goods and services sold
Within the monetarist view of an economy, if there is an increase in either the money supply or money velocity, and the quantity of goods and services sold is constant, the result must be an increase in the average price—inflation, in other words.
Applying this monetarist principle, the lack of inflation post-2008 was the result of the increase in the money supply being offset by declines in the velocity. Because of this offset, the capacity of the Fed to increase inflation even a little bit was effectively nullified.
During the lockdowns of the 2020 Pandemic Panic, money velocity dropped to such a degree that most if not all of the initial expansion of the money supply was also effectively nullified. This gives some idea of just how severe and draconian the lockdown policies actually were—the economy quite literally “stopped”.
Why did inflation as measured by the CPI start rising almost as soon as the economy nominally emerged from recession in mid 2020?
Ironically, Richmond Fed President Tom Barkin rather mis-stated the reason:
And a slowdown from our current situation must be kept in perspective: We are out of balance today because stimulus-supported excess demand overwhelmed supply constrained by the pandemic and global commodity shocks.
Calling the demand in 2020 and even now “excess demand” is more than a tad technocratic and truly unrealistic. Demand today is only “excess” because supply was chopped off at the knees. With the “Q” in the above equation driven in some cases to zero or near zero, any “demand” (represented by the left hand of the equation “MV”) becomes “excess”. Thus the mere resumption of even some pre-lockdown activity, within this framework triggers an increase in “P”, because Q has been artificially suppressed.
The degree to which Pandemic Panic “stimulus” helped spur this along is debatable. Increases in money supply from mid-2020 on certainly would not help, but the money velocity data shows that the initial “shock therapy” of massive stimulus was effectively neutralized by the collapse in money velocity. A bunch of money was dropped into the economy straight away and it went nowhere—almost literally.
Yet the real shock to the system was the steep reduction in goods and commodities available for purchase. As early as April of 2020, the World Bank noted that energy and metals prices declined dramatically during the first quarter of 2020.
Agricultural commodities changed less—after all, even in lockdown people still need to eat!
Yet this was the inevitable consequence of the deliberate shutdown of the world economy: goods and commodities were effectively withdrawn from the marketplace. When the lockdowns began ending in mid 2020, the previous levels of demand were still there—but the goods and commodities weren’t.
Just as a drop in V negated an increase in M on the left hand of the quantity of money equation, a drop in Q necessitated a rise in P on the right hand side—and would have even if the money supply had been held constant.
Not A Monetary Phenomenon
Consequently, we are in a paradoxical position that, despite over a decade of reckless money supply expansion, the primary drivers of the price increases we are seeing today are not monetary in nature, but supply and logistical in nature. Inflation is not happening because of the money supply increase, but because of a goods supply decrease.
Which is to say this inflation is not a monetary phenomenon at all.
Yet the Fed proposes to respond to the situation with monetary tools. Since “Q” has been drastically reduced, the Fed proposes to restore some semblance of balance by now “quieting demand”.
Quite literally, the Fed’s monetary policy of the moment is to suppress and choke off demand to compensate for governments around the world having abruptly reduced available supply of just about everything. Since there’s less to buy, the Fed wants to curtail your capacity to buy.
That’s what Richmond Fed President Tom Barkin means when he speaks of the Fed having “the tools” to deal with the situation.
Yet the Fed is still stuck in the same policy trap as before 2020: shrinking the money supply means crashing the markets.
To be clear, there has been very modest decreases in the M1 money supply recently:
And there have been not quite so modest decreases in US stock indices:
The Rock And The Hard Place
The Fed can take one of two paths:
Path 1 is it continues to hike interest rates and generally tighten the money supply, shrinking the M1 and pushing down markets overall—and listens to the howls of Wall Street a la Paul Volcker. In this scenario, as interest rates rise people’s ability to pay for goods and services diminishes—the “excess” demand is squelched.
Path 2 is it abandons interest rate hikes and loosens the money supply in an effort to prop up the markets. The “excess” demand is therefore not squelched and price hikes likely continue for quite a while yet. Doing nothing about interest rates and the money supply is effectively the same thing, and with the same result: Higher inflation, continued pressure on supply chains, and increasing shortages of goods and ultimately services.
Heads the Fed doesn’t win; tails the Fed simply loses.
Ironically, the impact on interest rates might not even be all that significant in the current situation. Unlike before 2008, when the Federal Funds Rate was higher than the 10-Year Treasury Yield, today the Federal Funds Rate is roughly half the 10-Year Treasury Yield.
If the drivers of Treasury Yields are predominantly factors other than the Federal Funds Rate—as appears to be the case at least in the present circumstance, continued raises in the Federal Funds Rate are likely to have uneven and problematic impacts on Treasury Yields.
The Fed Is Not In Control
The Federal Reserve has the means to shrink the money supply. It has marginally demonstrated that capacity in recent months.
What the Fed does not have is the means to moderate the impacts of whatever it does on the money supply. A very transitory reduction of 0.4% in the M1 in April (reversed in May) correlated to a roughly 5% drop in the Dow Jones—and the M1 reversal in May did not have a correlating Down Jones reversal.
Which means the markets should probably get used to one basic concept—a market crash is unavoidable. Even if the Fed should restart formal quantitative easing, the magnitude of the easing already done since 2008 limits the potential impacts of such a policy, making market resuscitation all but impossible. Continued tightening only exacerbates the market declines to date.
Heads the Fed doesn’t win. Tails the Fed simply loses.
At the end of Part 1 I asked the question “What was the Fed thinking?”
As best I can determine, they weren’t. At all. In the 40 years since the Volcker rate hikes, the Fed has become so accustomed to fiddling and futzing with the money supply and interest rates that it became simply assumed that whatever policy objective they desired would be the outcome of whatever fiddling and futzing they did.
Suffice it to say, they were wrong. Now they’re caught between a monetary rock and an interest hard place—and so are we all.
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