Monday, January 25, 2016

The Fed's dilemma

M*V = P * Q
Money stock x Velocity = Price x Quantity
Aggregate Monetary Purchasing Power = Aggregate Demand (or Output)

Inflation happens when money supply growth is faster than GDP growth.
Money supply growth has been rapid in recent times averaging about 6%.  GDP growth has been a lot less.  There hasn’t been strong inflation because Velocity of money has been declining which is offsetting the growth in the Money Supply.  Velocity declines when interest rates decline.  The Fed wants to normalize the economy by increasing interest rates in order to increase Velocity and also they want to reduce the growth of the money supply to prevent inflation by offsetting the increase in Velocity with a reduction in Money supply growth.  Just the reverse of what we have now.

But that is not what they are doing nor can they do it.  Yes, they can increase interest rates by increasing interest paid to banks on excess reserves.  But to decrease the growth of the money supply they need to decrease reserves.  They can’t because reserves are so large  such that when they reduced reserves enough to affect the growth of the money supply they will have removed so much liquidity in the system to cause a financial collapse and a depression.

There is another problem.  Goosing the economy is the end goal of Keynesian economics.  But the net of M*V doesn’t have that much of an effect on Q, contrary to Keynesian belief.  But it does have a big effect on P.

Where are we now inflation-wise.  Core CPI is at 2%.  Raising interest rates from here will increase velocity without the offsetting effect of a decline in the growth of  Money and will therefore increase P since Q is just not affected that much by M*V.

Q is affected by the productive utilization of savings.  That is a ‘nuther lesson.

Inflation is strong for the things we need and offset by low inflation on the things we don’t need.   Low oil prices are helping to reduce inflation on one of the things we need which is gasoline.

Conclusion:  The Fed will create inflationary pressures if they raise interest rates because doing so increases the velocity of money.  And the Fed is unable to reduce the growth of the money supply to offset the increase in velocity because reserves are so large.  And even if they could increase aggregate monetary purchasing power it doesn’t affect output very much but affects price a lot more.  So should the Fed increase interest rates in the face of a slowing economy with a pretty fast rate of money supply growth we can get stagflation.

I don’t ever predict interest rates.  I have no idea what the Fed will do now.  They last said they would likely raise rates four more time in 2016.  Many pundits predict they won’t in the face of a slowing economy.

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