Economist John Taylor of Stanford is worried that the appetite for liquidity is rising… again. The source for this concern starts by recognizing that “quantitative Easing (both I and II) has caused the monetary base—the sum of currency and bank reserves—to explode in the past three years, but has not resulted in similarly large increases in the growth of broader measures of the money supply such as M2,” he writes. Why hasn’t M2 followed suit? Because banks are sitting on the liquidity injected into the system.
The net effect is clear in a graph supplied by Taylor. The sharp rise in the monetary base (right scale) contrasts with the decline in the M2 multiplier (left scale). “But if you look closely at the lower right of the graph, you can see that this pattern may have shifted recently as the M2 multiplier increased,” he adds. This could be a sign that inflationary risks are rising. Alternatively, the uptick in the M2 multiplier may reflect a rising demand for money, in which case the risk of inflation is low. “It’s probably too early to tell for sure,” Taylor opines, “but the Fed’s weekly Money Stock Measures, released each Thursday afternoon, will be important to monitor in the weeks ahead.”
The early clues, Taylor continues, suggest that there’s an increase in money demand bubbling. If so, it’s a discouraging shift because it signals more trouble for the economy. As David Beckworth (assistant professor of economics at Texas State University) recently observed: “The anemic economic recovery can be tied to the ongoing elevated demand for safe and liquid assets.” Beckworth continues:
Paul Krugman and Brad DeLong refer to this phenomenon as a liquidity trap; I like to call it an excess money demand problem. Either way the key problem is that there are households, firms, and financial institutions who are sitting on an unusually large share of money and money-like assets and continue to add to them. This elevated demand for such assets keeps aggregate demand low and, in turn, keeps the entire term structure of neutral interest rates depressed too. (Note, that since term structure of neutral interest rates is currently low, it makes no sense to talk about raising interest rates soon. That would push interest rates above their neutral level and further choke off the recovery.)
In a post from earlier this week, Beckworth recommends “paying more attention to the build up of money assets in household balance sheets. Until this development changes, there will be an ongoing drag on nominal spending. One way to address this problem is to introduce a nominal GDP level target.”
Excess demand for money, Beckworth and other like-minded economists argue, is at the root of the current economic malaise. The solution can be found in the appropriate monetary policy. If demand for money rises, a central bank should satisfy that demand to stave off deflation and low/negative economic growth. It’s debatable if the Fed has effectively satisfied this demand. But if demand is rising once more, as Taylor suggests, the economic headwinds may be set to rise.
Bruce Bartlett, a former advisor in the Reagan and George H.W. Bush administrations, focused on the problem earlier this month by noting that the velocity of money has fallen and seems to be headed for another drop:
One way that the rise and fall of spending can be visualized is by looking at the velocity of money. This is the speed at which money turns over in the economy. When velocity rises, more G.D.P. is produced per dollar of the money supply. When velocity falls, the economic impact is exactly the same as if the money supply shrank by the same percentage.
The chart below comes from the Federal Reserve Bank of St. Louis and shows velocity as the ratio of the money supply (M2) to nominal G.D.P. It rose from 1.85 in 2003 to 1.96 in 2006. It has since fallen to a current level of 1.66. Thus one can say that each $1 increase in the money supply produced almost $2 of G.D.P. in 2006 and only $1.66 today.
Bartlett writes that the Fed “could have offset the decline in spending and velocity resulting from the fall in home prices with a sufficient increase in the money supply. And it tried. Since 2006, money supply has increased by about $2 trillion. But velocity fell faster than the money supply increased as households reduced spending and increased saving — the saving rate is now over 5 percent — and banks and businesses hoarded cash.”
Will the Fed try again? Some pundits think Ben Bernanke will announce a new round of quantitative easing (QE3) in his speech tomorrow at the Jackson Hole conference. Maybe, but there are plenty of reasons to remain skeptical. Bernanke was attacked for rolling out QE2 last year and some analysts predict that he’ll simply let the status quo prevail. In any case, the stakes are high once more.
“The market is treating Bernanke’s speech tomorrow almost like a policy meeting,” Steve Barrow, the London-based head of Group-of-10 currency research at Standard Bank Plc, advises via Bloomberg. “If he signals QE3, it could support higher-yielding assets like stocks, the Scandinavian currencies and the Aussie and kiwi dollars at the expense of the U.S. dollar. If the market is disappointed, then it could see a return to risk-off.”
This post originally appeared at The Capital Spectator and is reproduced here with permission.
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