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Checking-in on the Quantity Theory of Money
First a quick recap:
If
Monetary base ≈ Fed’s Balance Sheet Liabilities ≈ (Currency + Bank Excess Reserves)
and
(Monetary base x Money Multiplier) ≈ Monetary Supply ≈ M2
and
Velocity of Money ≈ GDP/M2
then
MV = PY
can be pleonastically re-written as
((excess reserves + currency) x (M2/(excess reserves + currency))) x (Nominal GDP / M2) = PY
The graphs below show that:
1. Monetary Base is up by a lot (Fed is buying)
2. Monetary Supply is up by very little (banks aren't levering)
3. Velocity of Money is down significantly (people aren't spending)
Now the 2y inflation breakeven in the US (the spread between the 2yr TIPS and the 2yr Treasury note) recently turned negative again after a short period of bamboo euphoria. With the amount of slack in the economy that most people expect, I'll leave it up to the kind reader to decide if this all looks fairly priced:
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QTM and its ugly step-child QE is dead, a failed theory applied by really smart people who lack wisdom (Bernanke, et al). The (negative) Marginal Productivity of Debt rules. The failed and flawed application of QTM cannot overcome its master which is the current monsterous overcapacity of debt destroying the massive excess production capacity that cannot be sustained.
The Mother of All Negative Feedback Loops is alive and well.
Have you guys seen this? I don't have a lot of knowledge of monetary theory, I'd really like to hear your thoughts, if any. Keen seems pretty convincing to me. http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/
this is a phenomenal post...
leaving academia behind, doesnt it make sense that the government know that it cant risk deflation for fear of further writedowns in the financial system?
I think it also knows that it cant have stagnant inflation because we dont have enough money to cover marking or current writedowns if they cant get values back up...
Additionally, if you knew you were going to have to devalue the currency at some point, wouldnt you spend like crazy (we all would) while people would still take your currency because it wont be worth s--- in a few years anyway...
taking out retarded as the rational for congressional spending, could this be a reason for the absolutely insane spending with no care for repercussions? By that I mean they all know it is coming?
would you as the president meet with your banks executive officers (like maybe the reason the president was in NYC @ citi yesterday) to tell them to take the tarp money and work to convert it to other currencies and hard assets (and raise as much debt from foreigners as you can) so when we drop the hammer, everyone is all in and we can be on top, because we just pull, as a county, a GS-like move on the rest of the world
I have a lot riding on this...I am so sure that inflation CANNOT be created by printing money, nor any attempt to increase the money supply.
Inflation is caused by the increase in non-productive employment, and only that. So this is a real world experiment for my theory.
I may be showing my ass, but printing money and releasing money out into the wild for the huddled masses to spend are two different things..no? Then again that all depends on how you measure inflation (kind of like employment).
2%/day with 20:1 up to maximum position size.(Risk reduces thereafter).
Would someone please prove that this model has any historical reliability as a predictor of either future inflation or markets values (equity, futures, bond)? Otherwise this is just another meaningless exercise on the latest fad: liquidity theory.
The equation,
M*V = P*Y = GDP,
with V = GDP / M
reduces to,
GDP = P * Y = M * V = M * (GDP / M) = GDP.
which is a tautology and says nothing.
How about writing your next article on the equation,
E*Z = P*Y
E = # of Eskimos and,
Z = GDP per Eskimo = GDP / E = P*Y / E
and analyze how the number of Eskimos is affecting inflation?
Well, it is pretty obvious that he rewrote it to make his nice graphs clearer and easier understood. I mean he basically winds up with graph1*graph2*graph3 = P*Y.
Graph1 is increasing. The two other decreasing. Obvious consequence to why prices hasn't and why sterilization will be needed if not to.
It's a pretty neat way to capture what's happening according to me.
Not to be pedantic but the 2 yr TIPS/2 yr note spread is telling you that the market expects the govts CPI measurement of inflation to be 0. Inflation in the real world could be anything.
>>The Fed's minutes today suggest they're going to fight a rise in M by paying interest on bank reserves at the Fed
While the Fed are at it maybe they'll pay me not to work.
Basic mechanics of TIPS (minutiae may be off):
Yields on TIPS are real time.
Return on TIPS are basically like every other bond, with a face value and coupon (semi-annual?) based on that face.
The inflation protection comes in the recalculation of the face value on coupoun distribution dates (?) by muliplying it by the the gross inflation rate (1+CPI), so your YTM increases in proportion with inflation.
Therefore, TIPS usually trade at a premium to Treasuries (lower yield) and that yield difference is a proxy for the market expectation of inflation for that duration.
Milton Friedman made 2 assumptions:
PY = MV ( Y being real GDP)
1. Velocity constant (meaning that Money supply doesn't impact velocity) 2. Real GDP over long run is a good proxy for Potential GDP
I don't know if we can say that Friedman is wrong on a day to day basis. But if you look at history, it does appear that causation runs from Money Supply to Inflation. However, it seems that there is a lag as to when the Price level creeps up.
I was reading an article somewhere, and if you consider M3 instead of M2, the picture is even more scarier. With so much Institutional(banks) money being with parked with the Fed for a meagre.15% rate, there should linger no doubts that a day of reckoning will arrive - when the cash is released into the system.
As you said, if 2 yr TIPS- 2yr Treasuries <=0, investors are not being compensated for inflation. It indicates that investors are expecting no inflation in the short term. So can we infer - that they are assuming that Institutional money will be parked with Fed for the forseeable future? Then one can forget about GROWTH.
Could someone highlight how the yields on TIPS are calculated? Are the yields real time (i mean market based)?
"Fortunately for us in the short-term, Milton Friedman made the mistake whn he assumed that velocity was constant. If that really were the case, the US and Europe would be using fiat currency as wallpaper right now."
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Hilarious and so true. I get nervous when I claim Friedman was "wrong", akin to my childhood questioning of Jesus - please, lightning, don't strike me! It's good to see others with horsepower doing it as well.
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Great stuff man - excellent post.
Good comments all around. A few thoughts:
- Variations on MV=PY are indeed just accounting identities. but the point should be clear - an increase in MV hasn't happened yet. When it does, it will probably be matched by an increase in P, unless M is sterilized. The Fed's minutes today suggest they're going to fight a rise in M by paying interest on bank reserves at the Fed: the hope is that this would encourage banks to keep the money base in the form of reserves, rather than coverting it to high-powered money supply. That may or may not work effectively. Fortunately for us in the short-term, Milton Friedman made the mistake whn he assumed that velocity was constant. If that really were the case, the US and Europe would be using fiat currency as wallpaper right now.
- M2 is simply a proxy for money supply - it's riddled with holes plugged by the sinewy fingers of the shadow banking system.
- The difference between the 2yr TIPS and the 2yr Treasury note is basically flat, which means that (ignoring financing/liquidity idiosyncrasies in the TIPS markets) the market expects inflation to be roughly 0% over the next two years, and is thus indifferent between holding TIPS and regular Treasuries.
Nice post. I went back to studying my basics.
Here is a nice article for the uninitiated:
http://news.goldseek.com/MillenniumWaveAdvisors/1209326748.php
Now could someone enlighten me about the 2 year TIPS and 2year Treasury break even? What is that indicating? That TIPS investors are not being compensated with a premium? What is the connection?
"bamboo euphoria" - That one just cracked me up. Great phrase.
A decrease in V can be offset by an increase in M, and visa versa. If monetary base holds static, and V decreases, it's really the same effect as if M decreased.
Deflation by deceleration.
You are aware that the measure of monetary supply mentioned is not universally accepted?
((excess reserves + currency) x (M2/(excess reserves + currency))) x (Nominal GDP / M2) = PY
The above eqaution does not tell you anything. It is just an identity. 1 = 1. Blinding glimpse of the obvious.
What matters in the MV = PY equation is relative change in the real GDP versus change in the monetary base, or change in inflation and more importantly, inflation expectations. Or if you like model masturbation, the rate of change and the change in rate of change of those variables.
The reason that inflation has not risen is that the velocity of money, through lending propensities has fallen so significantly. (ie. reserves are way up and mortgage lending is all but dead without refinancing- which is just rollover of existing debt)
If reserve accumulation declines, and/or Federal debt becomes monetized through decrease in the value of the securitizations that the Fed purchased in exchange for those reserves, MV will spike. And as the real economy, Y, is going everywhere but up- increase in MV = increase in P.
Great post.
This is why all the money the Fed pumped in has not resulted in inflation (yet)!
Anon,Well said!
And this is a great post!
Thanks Nick.
"Slack" in the economy assumes capacity is held constant in the face of declining demand. I don't think this is a realistic assumption.
While banks may not be lending their excess reserves out to their normal private customers, at some point they will loan that money to the US Govt, which will spend the money.
"MV is slowing but I am not sure that it will contract for 10 years? "
naw, thinking more like 20 years.... tomorrow's production must pay for both tomorrow's consumption AND past consumption (ie debt). V suffers greatly from saving; ie debt service.
Today the 2 yr break even of -.03 looks like a difficult call to make but look at 10 yr breakevens. MV is slowing but I am not sure that it will contract for 10 years? 1.64? Is that a fair valuation? I would think that the long term trend for the dollar will be down and not up, so where was oil when the dollar was at 1.60?
Does high oil mean that inflation will flow through to CORE CPI?
Every question just leads to another question.
Very much enjoying NickBarbon's commentary.