Understanding Money Supply and the Federal Reserve
I have to disagree with the talking heads I've seen on television recently, warning investors of hyper inflation. According to these 'experts' a serious bout of inflation is imminent due to the tremendous injections of liquidity by the Federal Reserve. I believe these pundits are overlooking one of the most basic factors in economics and I fear some of the talk is more politically motivated than financially motivated. While it is true that the Federal Reserve has been pumping money into our economy, the important thing these pundits miss is the 'why'.
There are two components to the effective money supply in the US economy. One is the amount of cash flowing through the economy, and the second is the velocity of the cash flowing through the economy. Of the two, the velocity of money is the more important.
If you studied economics is college you will recall that the velocity of money is normally a function of bank reserve requirements, which are set by the Fed. Simply put, if the reserve requirements are set at 20% then each dollar does the work of five dollars (100/20). If the reserve requirements are set at 10% then each dollar does the work of $10 (100/10).
I say under normal conditions because what we have seen during this credit crunch is anything but normal. Usually banks lend as much as they are allowed to lend based on the reserve requirements. That is how they make profits. However, because of loose lending standards in the past and questionable reserves, lending in our economy has slowed to a virtual crawl. Couple this decreased lending with increased reserve requirements for non bank financial entities such as Merrill Lynch, Morgan Stanley, and Goldman Sacks and you have created a serious speed bump for the velocity of money in our economy.
As lending contracts, the velocity of money in our system contracts. Because velocity is usually a multiplier of the physical currency in circulation any contraction in velocity reduces the effective liquidity in our economy many times.
The Federal Reserve's policy of providing liquidity to our ailing economy is not currently inflationary, it is simply an attempt to offset the slowing velocity of money. Without this infusion of liquidity there is a real danger of deflation, which is much harder for the Fed to fight than inflation. It is easier to slow the economy down than it is to speed the economy up.
The Federal Reserve will need to be vigilant as the economy eventually improves. The liquidity injected into the system could become inflationary as the velocity of money through our economy accelerates. But that won't occur until the credit crunch abates, which is a problem we would all like to see come sooner rather than later. Until then investors should not be overly concerned with inflation. Coming to the party too soon is nearly as bad as staying too late.
There are two components to the effective money supply in the US economy. One is the amount of cash flowing through the economy, and the second is the velocity of the cash flowing through the economy. Of the two, the velocity of money is the more important.
If you studied economics is college you will recall that the velocity of money is normally a function of bank reserve requirements, which are set by the Fed. Simply put, if the reserve requirements are set at 20% then each dollar does the work of five dollars (100/20). If the reserve requirements are set at 10% then each dollar does the work of $10 (100/10).
I say under normal conditions because what we have seen during this credit crunch is anything but normal. Usually banks lend as much as they are allowed to lend based on the reserve requirements. That is how they make profits. However, because of loose lending standards in the past and questionable reserves, lending in our economy has slowed to a virtual crawl. Couple this decreased lending with increased reserve requirements for non bank financial entities such as Merrill Lynch, Morgan Stanley, and Goldman Sacks and you have created a serious speed bump for the velocity of money in our economy.
As lending contracts, the velocity of money in our system contracts. Because velocity is usually a multiplier of the physical currency in circulation any contraction in velocity reduces the effective liquidity in our economy many times.
The Federal Reserve's policy of providing liquidity to our ailing economy is not currently inflationary, it is simply an attempt to offset the slowing velocity of money. Without this infusion of liquidity there is a real danger of deflation, which is much harder for the Fed to fight than inflation. It is easier to slow the economy down than it is to speed the economy up.
The Federal Reserve will need to be vigilant as the economy eventually improves. The liquidity injected into the system could become inflationary as the velocity of money through our economy accelerates. But that won't occur until the credit crunch abates, which is a problem we would all like to see come sooner rather than later. Until then investors should not be overly concerned with inflation. Coming to the party too soon is nearly as bad as staying too late.
Labels: credit crunch, deflation, economics, federal reserve, inflation, money supply
posted by Joe Taylor at 10:29 AM
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