Federal Reserve Tapering – Let Velocity Reign!

In an earlier post, I explained that the reason QE is non-inflationary is because the expansion of the monetary base has been offset by a significant slowdown in the velocity of money. Put simply, people in the QE economies are not spending the money that the Central Banks are dropping from their helicopters thousands of feet up in the sky.

My Central Banking mates know this and are at a loss to explain it…its a pity the popular press and the finance industry still believe that the ‘liquidity injection’ is inflating asset prices – which its not – and they would be better served pondering how velocity will react when the US Fed starts shrinking the monetary base.

One interesting opinion on the velocity phenomenon is that it reflects the classic Keynesian Liquidity Trap. Roughly speaking, this kitchen sink piece of theory holds that when interest rates are low, velocity declines as individuals prefer to hold paper money as a ‘speculative demand’ in their portfolios. The argument is that the ZERO rate of return on cash will protect against losses in the bond markets when interest rates rise. This is clearly a rubbish argument – just check your own wallet and tell me how much more cash it holds versus the same time three years ago. People are not hoarding the paper money dropping from helicopters as the Keynesian view requires.

On the contrary, velocity is low because of a lack of demand for credit or anything that ramps up leverage. Were individuals and corporations expecting interest rates to rise, they would be borrowing long-term debt like crazy and spending, since this would lock-in cheap money. Velocity would therefore be rising under this scenario, which its not.

So what does this mean for the Fed? Curiously, the problem the Fed faces is jump-starting velocity to replace the reduction in the monetary base when they withdraw their asset purchases. If velocity stays low, the Fed’s tapering actions will actually be deflationary, thereby lowering interest rates and raising bond prices … ponder this for a moment.