US Monetary Policy Transmission Mechanism: Set to Change in 2014?
One of the salient features of the financial environment since the collapse of Lehman Brothers in 2008 has been the ability of the Fed to boost the money supply (M2) without generating inflation. In fact, the opposite appears to have happened: deflation is a still residual threat to the US economy. The monetary transmission mechanism providing stimulus to the real economy appears to have broken down. There are three sequences that indicate the transmission process is working normally: 1) rising bank reserves boosts the monetary base, 2) broad money supply (M2) starts rising as banks use deposits as managed liabilities to fund lending, and 3) bank credit finally starts increasing. The growth of M2 relative to the monetary base has been far lower in this recovery, indicating a collapse in the so-called money multiplier. Meanwhile, bank credit growth has been particularly erratic, suggesting that things are not quite right with the transmission mechanism. Could things change in 2014?
Velocity of Circulation of Money: A Game Changer for the Fed?
The velocity of circulation of money has fallen dramatically since 2008. Normally, it will exhibit pro-cyclical attributes, rising during expansions and contracting during recessions. The continued decline since the expansion began in 2009 Q3 has led some commentators to conjecture that it simply reflects the “new normal,” where households have both reduced leverage and possess a lower propensity to consume. If correct, this view will have huge implications for Fed policy: removing monetary accommodation is not really an option due to deflationary risks. The main caveat concerning this view is, however, that turning points for the economy and the velocity of circulation of money are not always coincident. Typically, money velocity will continue to decline after the economy has bottomed. What we are seeing in the current recovery is not, therefore, violently at odds with economic and financial history. What has been unique is the extraordinary magnitude of the velocity contraction.
The Fed will have undertaken rigorous analysis as to why money velocity has continued to drop. Falling velocity reflects so-called liquidity preference, the desire of the private sector to hold cash. The corporate sector has built up significant levels of cash since the recovery began. Meanwhile, the banking system has also seen a surge in liquidity preference, with very high levels of cash assets being held relative to bank credit. Lower liquidity preference will signal an inflexion point for money velocity to start rising again. This would beg questions about the sustainability of the Fed’s current accommodative stance.
Catalysts for Rising Money Velocity
Although the Fed has a dual mandate, the Federal Open Market Committee (FOMC) has placed a higher policy weight to reducing unemployment. A strengthening labour market would bolster consumer confidence. Higher and sustained levels of confidence have historically been associated with rising money velocity. The fragility of consumer confidence during this post-Great Recession recovery has largely been due an uneven pace of labour market improvement and the elevated duration of unemployment. This has depressed discretionary spending in the economy and money velocity. Future improvements in labour market conditions should bolster consumer confidence and boost money velocity due to improving “animal spirits” amongst households.
Financial conditions have historically played a role in producing rising money velocity. Firstly, compressing credit spreads between high yield corporate bonds and Treasury securities have been a harbinger for rising velocity. Under the three tranches of quantitative easing, credit spreads have narrowed significantly, although fears of Fed tapering took a modest toll between May and September. History would suggest that, at some point, money velocity should start rising. Secondly, flattening yield curves have presaged rising velocity. Under the auspices of quantitative easing, the yield curve has flattened due to the onset of a lower term premium vis-à-vis rising short-term interest rates. The yield curve has steepened in 2013, and this alone is not supportive for an improvement in money velocity in the near-term. Rising short-term interest rates will probably be required to decisively produce a flatter yield curve, but this is highly unlikely to happen soon. Credit market conditions are, therefore, sending mixed signals about the likelihood of rising money velocity.
Will Rising Velocity Produce Rampant Overheating?
The US economy has been stuck in second gear since the recovery began. As a result, resource utilisation in the economy still seems far from stretched. Deflationary forces still worry Fed policymakers, providing them with sufficient reasons to maintain the extraordinarily accommodative policy stance. For the time being, investors are confident that inflation will remain benign and believe the Fed will do whatever is necessary to prevent inflationary expectations becoming unhinged. Can these seemingly benign views about accommodative policy and inflation risks change in 2014? Financial markets can be driven by extremely fickle expectations. While the US economy is unlikely to experience rampant inflation or overheat any time soon, the very fear of such outcomes, produced by rising velocity, could have a significant bearing on financial markets.
Investment Implications of Rising Money Velocity
The behaviour of inflationary expectations will be the key determinant as to how financial assets perform once money velocity starts rising. Historically, rising velocity has been associated with higher inflation. Given the huge monetary stimulus put in place by the Fed, any rise in velocity in 2014 presents the FOMC with potential overheating and inflation risks. In the near-term, perceptions of faster growth could produce a temporarily beneficial backdrop for risky assets, based on improved expectations for corporate profits. How long could this last? Much will depend on the behaviour of bond yields. If inflationary expectations became quickly unhinged, then equities would be living on borrowed time, because the Fed would be forced to promptly slam the monetary brakes. Historically, equities have struggled once money velocity starts rising, because bond yields typically rise in anticipation of a return to normal economic and monetary conditions.
There are also implications for other financial markets based on evidence of a recovery in money velocity. Firstly, there would be downward pressure on the exchange rate due to the improvement in the so-called money multiplier. This would constitute a further easing of monetary conditions. Secondly, due to their sensitivity to changes in monetary conditions, there would be upward pressure on commodity prices. The combination of a weakening exchange rate and rising commodity prices would be detrimental to keeping inflationary expectations well-anchored. This would put further upward pressure on bond yields. The extent to which inflationary expectations rise will be determined by how quickly the Fed drains excess reserves in the banking system.
Fed Policy and Rising Money Velocity
The Fed has undertaken a major expansion of its balance sheet relative to GDP. If there was clear evidence that money velocity was increasing, then the Fed would need to think of an exit strategy. Policy focus would be diverted from reducing unemployment to draining excess reserves. Conventional open-market operations are ill-equipped to drain $2.5 trillion in excess reserves. The last time the Fed’s balance sheet was so elevated was in the mid-1940’s, following the banking crisis during the Great Depression. It took approximately thirty five years to shrink the balance sheet relative to GDP to those levels that preceded the crisis in 1933.
The Fed could potentially make extensive use of the so-called tri-party repo market to simultaneously shrink its balance sheet and drain excess reserves. Unlike conventional repos, the tri-party market will facilitate cash management and short-term borrowing for a wide range of financial intermediaries using a broad range of financial asset groups. In terms of size, this market peaked at $2.8 trillion in 2008 and has subsequently shrunk to $1.6 trillion. Draining the banking system of $2.5 trillion in excess reserves in a hurry would severely test the capacity of this market. The bottom line is that there is no easy fix for the Fed to rapidly exit its accommodative policy posture. This means that any unexpectedly sharp rise in money velocity could put severe pressure on bond yields, insofar as the Fed is deemed to have limited firepower to quickly drain excess reserves. In this scenario, equities would face a tough combination of rising inflationary pressures and bond yields. This would be similar to what happened in 1987. The events of October 1987 are part of financial market history. If 2014 is the year of inflexion for money velocity, the Fed will no doubt be hoping that any increases will be both modest and gradual, providing the FOMC with some breathing room. The big difference between 1987 and 2014 is the stance of US fiscal policy. In 1987, fiscal profligacy was cited as a factor behind rising bond yields, while in 2014 some continued form of fiscal tightening remains the most likely outcome.
Summary and Conclusions
The Fed has been able to significantly ease monetary conditions since the financial crisis without generating inflation due to a compromised transmission mechanism. This has resulted in the erratic growth of bank credit.
The velocity of circulation of money has fallen dramatically since 2008, indicating a sharp rise in the demand for money by the private sector. The decline has continued even after the economy began recovering. Any reduction in liquidity preference in the banking system will boost the chances of a recovery in money velocity.
A sustained rise in consumer confidence, resulting from improved labour market conditions, could boost money velocity by supporting more discretionary spending. Financial market conditions are, however, sending mixed signals about the likelihood of a rise in velocity.
Rising money velocity is unlikely to produce immediate signals of inflation or overheating, but it may introduce an element of doubt into investors’ currently benign inflationary expectations.
The behaviour of inflationary expectations in the wake of rising money velocity will be critical in determining the implications for financial markets. A rapid unhinging of inflationary expectations will have a bearish outcome. Risky assets have typically struggled during periods of rising money velocity. The dollar exchange rate will weaken and commodity prices would increase, putting further upward pressure on bond yields.
Relative to GDP, the Fed’s balance sheet is at its most bloated since 1945. It took thirty five years to return to the levels prior to the 1933 banking crisis. There are no easy channels through which the Fed can rapidly shrink its balance sheet if money velocity rises more rapidly than expected, placing further upward pressure on bond yields.
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