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Why the M2 Slowdown Doesn’t Blunt My Inflation Concern

April 12, 2018 1 comment

We are now all good and focused on the fact that inflation is headed higher. As I’ve pointed out before, part of this is an illusion of motion caused by base effects: not just cell phones, but various other effects that caused measured inflation in the US to appear lower than the underlying trend because large moves in small components moved the average lower even while almost half of the consumption basket continues to inflate by around 3% (see chart, source BLS, Enduring Investments calculations).

But part of it is real – better central-tendency measures such as Median CPI are near post-crisis highs and will almost certainly reach new highs in the next few months. And as I have also pointed out recently, inflation is moving higher around the world. This should not be surprising – if central banks can create unlimited amounts of money and push securities prices arbitrarily higher without any adverse consequence, why would we ever want them to do anything else? But just as the surplus of sand relative to diamonds makes the former relatively less valuable, adding to the float of money should make money less valuable. There is a consequence to this alchemy, although we won’t know the exact toll until the system has gone back to its original state.

(I think this last point is underappreciated. You can’t measure an engine’s efficiency by just looking at the positive stroke. It’s what happens over a full cycle that tells you how efficient the engine is.)

I expect inflation to continue to rise. But because I want to be fair to those who disagree, let me address a potential fly in the inflationary ointment: the deceleration in the money supply over the last year or so (see chart, source Federal Reserve).

Part of my thesis for some time has been that when the Fed decided to raise interest rates without restricting reserves, they played a very dangerous game. That’s because raising interest rates causes money velocity to rise, which enhances inflation. Historically, when the Fed began tightening they restrained reserves, which caused interest rates to rise; the latter effect caused inflation to rise as velocity adjusted but over time the restraint of reserves would cause money supply growth (and then inflation) to fall, and the latter effect predominated in the medium-term. Ergo, decreasing the growth rate of reserves tended to cause inflation to decline – not because interest rates went up, which actually worked against the policy, but because the slow rate of growth of money eventually compounded into a larger effect.

And so my concern was that if the Fed moved rates higher but didn’t do it by restraining the growth rate of reserves, inflation might just get the bad half of the traditional policy result. The reason the Fed is targeting interest rates, rather than reserves, is that they have no power over reserves right now (or, at best, only a very coarse power). The Fed can only drain the inert excess reserves, which don’t affect money supply growth directly. The central bank is not operating on the margin and so has lost control of the margin.

But sometimes they get lucky, and they may just be getting lucky. Commercial bank credit growth (see chart, source Federal Reserve) has been declining for a while, pointing to the reason that money supply growth is slowing. It isn’t the supply of credit, which is unconstrained by reserves and (at least for now) unconstrained by balance sheet strength. It’s the demand for credit, evidently.

Now that I’ve properly laid out that M2 is slowing, and that declining M2 growth is typically associated with declining inflation (and I haven’t even yet pointed out that Japanese and EU M2 growth are both also at the lowest levels since 2014), let me say that this could be good news for inflation if it is sustained. But the problem is that since the slowing of M2 is not the result of a conscious policy, it’s hard to predict that money growth will stay slow.

The reason it needs to be sustained is that we care about percentage changes in the stock of money plus the percentage change in money velocity. For years, the latter term has been a negative number as money velocity declined with interest rates. But M2 velocity rose in the fourth quarter, and my back-of-the-envelope calculation suggests it probably rose in Q1 as well and will rise again in Q2 (we won’t know Q1’s velocity until the advance GDP figures are reported later this month). If interest rates normalize, then it implies a movement higher in velocity to ‘normal’ levels represents a rise of about 12-14% from here (see chart, source Bloomberg.[1])

If money velocity kicks in 12-14% over some period to the “MVºPQ” relationship, then you need to have a lot of growth, or a pretty sustained decline in money growth, to offset it. The following table is taken from the calculator on our website and you can play with your own assumptions. Here I have assumed the economy grows at 2.5% per year for the next four years (no mean feat at the end of a long expansion).

The way to read this chart is to say “what if velocity over the next four years returns to X. Then what money growth is associated with what level of inflation?” So, if you go down the “1.63” column, indicating that at the end of four years velocity has returned to the lower end of its long-term historical range, and read across the M2 growth rate row labeled “4%”, you come to “4.8%,” which means that if velocity rises to 1.63 over the next four years, and growth is reasonably strong, and money growth remains as slow as 4%, inflation will average 4.8% per year over those four years.

So, even if money growth stays at 4% for four years, it’s pretty easy to get inflation unless money velocity also stays low. And how likely is 4% money growth for four years? The chart below shows 4-year compounded M2 growth rates back thirty or so years. Four percent hasn’t happened in a very long time.

Okay, so what if velocity doesn’t bounce? If we enter another bad recession, then it’s conceivable that interest rates could go back down and keep M2 velocity near this level. This implies flooding a lot more liquidity into the economy, but let’s suppose that money growth is still only 4% because of tepid credit demand growth and velocity stays low because interest rates don’t return to normal. Then what happens? Well, in this scenario presumably we’re no longer looking at 2.5% annual growth. Here’s rolling-four-year GDP going back a ways (source: BEA).

Well, let’s say that it isn’t as bad as the Great Recession, and that real growth only slows a bit in fact. If we get GDP growth of 1.5% over four years, velocity stays at 1.43, and M2 grows only at 4%, then:

…you are still looking at 2.5% inflation in that case.

I’m going through these motions because it’s useful to understand how remarkable the period we’ve recently been through actually is in terms of the growth/inflation tradeoff, and how unlikely to be repeated. The only reason we have been able to have reasonable growth with low inflation in the context of money growth where it has been is because of the inexorable decline in money velocity which is very unlikely to be repeated. If velocity just stops going down, you might not have high inflation numbers but you’re unlikely to get very low inflation outcomes. And if velocity rises even a little bit, it’s very hard to come up with happy outcomes that don’t involve higher inflation.

I admit that I am somewhat surprised that money growth has slowed the way it has. It may be just a coin flip, or maybe credit demand is displaying some ‘money illusion’ and responding to higher nominal rates even though real rates have not changed much. But even then…in the last tightening cycle, the Fed hiked rates from 1% to 5.25% over two years in 2004-2006, and money growth still averaged 5% over the four years ended in 2006. While I’m surprised at the slowdown in money growth, it needs to stay very slow for quite a while in order to make a difference at this point. It’s not the way I’d choose to bet.


[1] N.b. Bloomberg’s calculation for M2 velocity does not quite match the calculation of the St. Louis Fed, which is presumably the correct one. They’re ‘close enough,’ however, for this purpose, and this most recent print is almost exactly the same.

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RE-BLOG: Side Bet With Ben?

December 26, 2013 1 comment

Note: The following blog post originally appeared on June 14, 2012 and is part of a continuing year-end ‘best of’ series, calling up old posts that some readers may have not seen before. I have removed some of the references to then-current market movements and otherwise cut the article down to the interesting bits. You can read the original post here.

           

That said, there could be some signs that core CPI is flattening out. Of the eight ‘major-groups’, only Medical Care, Education & Communication, and Other saw their rates of rise accelerate (and those groups only total 18.9% of the consumption basket) while Food & Beverages, Housing, Apparel, Transportation, and Recreation (81.1%) all accelerated. However, the deceleration in Housing was entirely due to “Fuels and Utilities,” which is energy again. The Shelter subcategory accelerated a bit, and if you put that to the “accelerating” side of the ledger we end up with a 50-50 split. So perhaps this is encouraging?

The problem is that there is, as yet, no sign of deceleration in core prices overall, while money growth continues to grow apace. I spend a lot of time in this space writing about how important money growth is, and how growth doesn’t drive inflation. I recently found a simple and elegant illustration of the point, in a 1999 article from the Federal Reserve Board of Atlanta’s Economic Review entitled “Are Money Growth and Inflation Still Related?” Their conclusion is pretty straightforward:

“…substantial changes in inflation in a country are associated with changes in the growth of money relative to real income…the evidence in the charts is inconsistent with any suggestion that inflation is unrelated to the growth of money relative to real income. On the contrary, there appears to be substantial support for a positive, proportional relationship between the price level and money relative to income.”[1]

But the power of the argument was in the charts. Out of curiosity, I updated their chart of U.S. prices (the GDP deflator) versus M2 relative to income to include the last 14 years (see Chart, sources: for M2 Friedman & Schwartz, Rasche, and St. Louis Fed, and Measuring Worth for the GDP and price series). Note the chart is logarithmic on the y-axis, and the series are scaled in such a way that you can see how they parallel each other.

That’s a pretty impressive correlation over a long period of time starting from the year the Federal Reserve was founded. When the authors produced their version of this chart, they were addressing the question of why inflation had stayed above zero even though M2/GDP had flattened out, and they noted that after a brief transition of a couple of years the latter line had resumed growing at the same pace (because it’s a logarithmic chart, the slope tells you the percentage rate of change). Obviously, this is a question of why changes in velocity happen, since any difference in slopes implies that the assumption of unchanged velocity must not hold. We’ve talked about how leverage and velocity are related before, but an important point is that the wiggles in velocity only matter if the level of inflation is pretty low.

A related point I have made is that at low levels of inflation, it is hard to disentangle growth and money effects on inflation – an observation that Fama made about thirty years ago. But at high levels of inflation, there’s no confusion. Clearly, money is far and away the most important driver of inflation at the levels of inflation we actually care about (say, above 4%!). The article contained this chart, showing the same relationship for Brazil and Chile as in the chart updated above:

That was pretty instructive, but the authors also looked across countries to see whether 5-year changes in M2/GDP was correlated with 5-year changes in inflation (GDP deflator) for two windows. In the chart below, the cluster of points around a 45-degree line indicates that if X is the rate of increase in M2/GDP for a given 5-year period, then X is also the best guess of the rate of inflation over the same 5-year period. Moreover, the further out on the line you go, the better the fit is (they left off one point on each chart which was so far out it would have made the rest of the chart a smudge – but which in each case was right on the 45-degree line).

That’s pretty powerful evidence, apparently forgotten by the current Federal Reserve. But what does it mean for us? The chart below shows non-overlapping 5-year periods since 1951 in the U.S., ending with 2011. The arrow points to where we would be for the 5-year period ending 2012, assuming M2 continues to grow for the rest of this year at 9% and the economy is able to achieve a 2% growth rate for the year.

So the Fed, in short, has gotten very lucky to date that velocity really did respond as they expected – plunging in 2008-09. Had that not happened, then instead of prices rising about 10% over the last five years, they would have risen about 37%.

Are we willing to bet that this time is not only different, but permanently different, from all of the previous experience, across dozens of countries for decades, in all sorts of monetary regimes? Like it or not, that is the bet we currently have on. To be bullish on bonds over a medium-term horizon, to be bullish on equity valuations over a medium-term horizon, to be bearish on commodities over a medium-term horizon, you have to recognize that you are stacking your chips alongside Chairman Bernanke’s chips, and making a big side bet with long odds against you.

I do not expect core inflation to begin to fall any time soon. [Editor’s Note: While core inflation in fact began to decelerate in the months after this post, median inflation has basically been flat from 2.2% to just above 2.0% since then. The reason for the stark difference, I have noted in more-recent commentaries, involves large changes in some fairly small segments of CPI, most notably Medical Care, and so the median is a better measure of the central tendency of price changes. Or, put another way, a bet in June 2012 that core inflation was about to decline from 2.3% to 1.6% only won because Medical Care inflation unexpectedly plunged, while broader inflation did not. So, while I was wrong in suggesting that core inflation would not begin to fall any time soon, I wasn’t as wrong as it looks like if you focus only on core inflation!]


[1] The reference of “money relative to income” comes from manipulation of the monetary identity, MV≡PQ. If V is constant, then P≡M/Q, which is money relative to real output, and real output equals income.

Food Fight at the Fed!

September 23, 2013 2 comments

Now, now, children! Stop fighting! This is unbecoming!

It is apparent now that the disagreements in the FOMC – while nothing new – are becoming more significant and the hurly-burly is spilling into the public eye. It is somewhat amazing to me that the Fed is allowing this argument to be conducted in public (traditionally, all remarks by Fed officials are first vetted by the Chairman’s office). Today Dallas Fed President Richard Fisher actually questioned the Fed’s credibility! This article is worth reading, and not just for the part where Fisher says that Yellen is “dead wrong on policy.” It’s also fascinating that Fisher attributed the decision to delay the taper to “a perceived ‘tenderness’” in the housing recovery.

Below is a chart (source: Enduring Investments) of the ratio of median existing home sale prices to median household income. If this is “tenderness” in a recovery, it only shows a lack of knowledge of history: this is the second highest ratio of home prices to income we have since this particular data begins…and the first highest ratio sunk the global economy for a half-decade and counting.

updatedhousing

On the other side of the fence were the New York Fed’s Bill Dudley and the Atlanta Fed’s Dennis Lockhart, who lamented that (Dudley) there has been no pickup in the economy’s “forward momentum” and asked (Lockhart) “Is America losing its economic mojo?” These questions, and the result of these questions during the recent FOMC meeting, illustrate two points. First, that the bar for removing never-before-seen levels of monetary accommodation has been raised so high that doves believe it is appropriate to keep the foot on the accelerator until growth is drastically above-average. As I illustrated back at the beginning of August, it is unreasonable to expect more than about 200,000 new jobs per month to be created by the economy. Repairing all of the damage is simply going to take time. We would all love to see 5% growth, but is the Fed’s job really to make sure that happens, or to try and manage the downside (or, as I personally believe, to merely manage the price level)?

The second point that the Fisher/Dudley/Lockhart comments illustrate is that the doves at the Fed are clearly in control. The hawks were completely unable even to get a marginal tapering, although the Fed had clearly indicated previously that such a taper was likely to happen.

It is a Dudley/Bernanke/Yellen Fed (and they have allies too!), and anyone who thinks that the Fed is abruptly going to find religion once CPI peeks above 2% is fighting against all historical indications. One need only consider the fact that the post-FOMC meeting statement pointed out a “tightening of financial conditions observed in recent months,” a clear reference to the rapid rise in interest rates that accompanied the initial talk about tapering. But if the Fed begged off on the taper partly because of the tightening of financial conditions, that is the rise in interest rates that was caused by an expectation that the taper would stop, then the argument circular, isn’t it? It’s impossible for them to stop, since any indication that they were going to stop is obviously going to cause interest rates to rise, which would be a tightening of financial conditions, which would keep them from stopping… Does anyone seriously think that a core inflation print of 2.1% would change that?

To the extent that cutting from 20 cups of coffee per day to 19 cups of coffee per day could be called a “bold step,” wouldn’t the best time to take such a “bold step” with monetary policy be when the equity markets are at their highs and real estate markets back above their long-term value anchors?

And yet, the initial enthusiasm for the stock market for the continuation of QE seems to have faded rapidly. The entire post-FOMC rally that caused such joy around the offices of CNBC last Wednesday has been erased. Interestingly, the initial spike in commodities prices has also been erased, which is more curious since commodities prices don’t depend on growth as much as they do on inflation. And 10-year inflation expectations are back around 2.25%, basically the highest level they have seen since the Q2 swoon (see chart, source Bloomberg). So, as usual, I am flummoxed by the behavior of commodities.

10ybei

I know that there is a great deal of confidence in some quarters that the Federal Reserve can keep its foot on the gas until such time as inflation actually rises to a level that concerns them. I cannot imagine the reason for such confidence when the drivers of the car are such committed doves. There are multiple problems undermining my confidence in such a possibility. There is the “Wesbury hypothesis” that the Fed will adjust its definition of what worries them about inflation – a hypothesis which, after this month’s FOMC meeting, should be even more compelling. There is the fact that there is no evidence I am aware of that the Fed was able to easily restrain inflation after it came unglued in any prior episode (and no one knows where and when and how it will come unglued). And finally, it isn’t clear to me how the Fed would go about restraining inflation anyway, given the overabundance of excess reserves and the fact that those reserves insulate any inflation process against the tender ministrations of the central bank.

One thing seems to be sure. The food fight at the Fed is not likely to end soon, and together with the dysfunction on Capitol Hill is raises the very real question of whether anything economically helpful is going to be accomplished in Washington DC this year.

Higher Rates, Higher Credit Growth: Sober Look

September 21, 2013 Leave a comment

I wrote recently about money velocity and reminded readers that theory says higher interest rates tend to increase money velocity because it decreases the demand for real cash balances. This was around the discussion of whether the enormous demand for Verizon bonds could be anecdotal evidence that velocity is increasing.

Yesterday the blog Sober Look – which is one of my favorites because it gives intelligent looks at many different markets – ran an article entitled “Could rising rates fuel credit growth in the US?” in which they in turn cite Deutsche Bank research. It’s a very quick article and worth a read, because it sheds some light on one of the mechanisms by which credit growth may increase with higher rates. Ordinarily, higher rates inhibit money growth at the same time that they increase velocity, partly because the yield curve flattens. But in this case, higher rates may increase both credit growth and money velocity – at least when rates initially rise – since the market is moving ahead of the Fed and steepening the yield curve in a selloff.

It’s just another puzzle piece to rotate in your mind, to try and see how it all fits together!

 

Summary of My Post-CPI Tweets

September 17, 2013 10 comments

Here is a summary of my tweets after the CPI release this morning. You can follow me @inflation_guy.

  • CPI +0.1%/+0.1% core, y/y core to 1.8%. Core only slightly weaker than expected as it rounded down to 0.1% rather than up to 0.2%.
  • Housing CPI was weak, second month in a row. Rents will eventually catch up w/ housing prices…but not yet.
  • Apparel CPI was weak after a couple of strong up months. I’ll have the whole breakdown in a bit.
  • Core was actually only 0.13%, suggesting last August’s 0.06% and this August’s number might merely be bad seasonals.
  • Market was only looking for 0.17% or so, so it’s not a HUGE miss. Still disappointing to my forecasts as upturn in rents remains overdue.
  • Core CPI now 1.766% y/y. More difficult comparison next month although still <0.2%.
  • Accelerating major grps: Apparel, Medical Care, Educ/Comm, Other (20.9%); decel: Food/Bev, Housing(!), Transp (73.1%), unch: Recreation
  • Housing deceleration actually isn’t worrisome. Primary rents were 3.0% y/y vs 2.8% last. OER was 2.23% vs 2.19% last.
  • Housing subcomponent drag was from lodging away from home, household energy, other minor pieces. So housing inflation story still intact.
  • Core services inflation unch at 2.4% y/y; core goods inflation up to 0% from -0.2%. Source of uptick: mean reversion in core goods.
  • So OER still reaches a new cycle high at 2.23%…it’s just not accelerating yet as fast as I expect it to. Lags are hard!

The initial reading of this number, as the tweet timeline above shows, was negative. The figure was weaker-than-expected, and Housing CPI decelerated from 2.26% to 2.17%. This seemed to be a painful blow to my thesis, which is that rising home prices will pass through into housing inflation (expressed in rents) and push core inflation much higher than economists currently expect.

Housing CPI is one of eight major subgroups of CPI, the other seven being Food and Beverages, Medical Care, Transportation, Apparel, Recreation, Education and Communication, and Other. Housing receives the most weight, at 41% of the consumption basket and an even heavier weight in core inflation. So, a deceleration in Housing makes it very hard for core inflation to increase, and vice-versa. If you can get the direction of Housing CPI right, then you’ll have a leg up in your medium-term inflation forecast (although it isn’t very helpful in terms of projecting month-to-month numbers, which are mostly noise). Thus, the deceleration in Housing seemed discouraging.

But on closer inspection, the main portions of Housing CPI are doing about what I expected them to do. Primary Rents (aka “Rent of primary residence”) is now above 3%, in sharp contrast to the expectations of those economists and observers who thought that active investor interest in buying vacant homes would drive up the price of housing but drive down the price of rents. Though I never thought that was likely…the substitution effect is very strong…it was a plausible enough story that it was worth considering and watching out for. But in the event, primary rents are clearly rising, and accelerating, and Owners’ Equivalent Rent is also rising although less-obviously accelerating (see Chart, source BLS).

oerprimarySo, it is much less clear upon further review that this is a terribly encouraging CPI figure. It is running behind my expectations for the pace of the acceleration, but it is clearly meeting my expectations for what should be driving inflation higher. As I say above, econometric lags are hard – they are tendencies only, and in this case the lags have been slightly longer, or the acceleration somewhat muted, from what would typically have been expected from the behavior of home prices. Some of that may be from the “investors producing too many rental units” effect, or it might simply be chance. In any event, the ultimate picture hasn’t changed. Core inflation will continue to rise for some time, and will be well above 2% and probably 3% before the Fed’s actions have any meaningful effect on slowing the increase.

But How Near is the Fall?

September 16, 2013 Leave a comment

I will resist the temptation, succumbed to by many others, to offer a pithy title turning on some pun involving Larry Summers’ name. For example, I will not title this article:

  • Summers’ Not Lovin’
  • Summers of Our Discontent
  • Summer Happy, Summer Not So Happy
  • Cruel Summers
  • School’s Out For Summers, or
  • Lazy-Hazy-Crazy Days of Summers

Such tomfoolery is occasioned by the news yesterday that Larry Summers has withdrawn his name for consideration to be the next Fed Chairman, succeeding Bernanke. The markets reacted with similar tomfoolery. Although the equity markets hadn’t exactly plunged as Summers became the odds-on candidate (at a conference I went to last week, all six of the panelists during one segment said Summers would be the selection), stocks rocketed higher today as this supposedly makes a dovish Chairman more likely. Bonds rallied as well, and the dollar fell – all of these for the same reason. Strangely (but not so strangely if you have been watching commodities for the last couple of years), commodities fell on the potential for a more-dovish Chairman.

The odds-on favorite just became Janet Yellen, with Donald Kohn the runner-up. Both of these are considered to be more-dovish than Summers, which is odd because it is generally acknowledged that Summers had virtually no track record expressing his opinions on matters of monetary policy, and was essentially a policy unknown.

In any event, markets for the nonce are enjoying the notion that a Chairman Yellen or Kohn would bring “continuity” to the Federal Reserve and make the adjustment from the Bernanke years seamless. You can be a short seller of that idea. Volcker to Greenspan, Greenspan to Bernanke…neither of those transitions was expected to make a dramatic difference in monetary policy, but of course ultimately they did. Going back further, Volcker was chosen partly as an antidote for G. William Miller, so it is not surprising that things changed under Volcker – but we were looking for change). You probably have to go back to the Arthur Burns/G William Miller transition in the late 1970s to find a transition that truly didn’t matter very much, although that was mostly because Burns had made such a mess of things and triggered such an ugly inflation by adding too much liquidity to the system in order to cure the recession that the only thing Miller thought he could do was to continue on…

Oh. I see the parallel now.

In any event, a Chairman Kohn or Chairman Yellen is very likely to turn out to be something different from what we think we are getting, or from what the President thinks he is getting (not necessarily the same thing). It is much like appointing a Supreme Court justice: after donning the robes, physically or metaphorically, a justice might vote in a way very different from the way his nominator expected him or her to. Just ask G.H.W. Bush. So, regardless of whether the next Chairman is Yellen, Kohn, or some as-yet-unknown candidate, the bottom line is that investors should expect surprises. If your investment strategy is reliant on there not being any surprises, then I advise you to reconsider that strategy!

Speaking of surprises, Tuesday brings the CPI report. The market consensus is for +0.2% on headline and +0.2% on core inflation, with the y/y core inflation reading rising to 1.8% from 1.7%. However, since last year’s CPI print was a mere +0.06%, forecasting a rise is very easy. If the monthly figure is only 0.105%, y/y core inflation will still tick up to 1.8% (rounded). Indeed, the risk here is that it only takes a +0.21% to produce a 1.9%, which would make for some panicky portfolio adjustments even though it would not be an extreme outlier.

In my view we are probably overdue for a +0.25% print on core inflation. The current rise of core CPI back towards median CPI, which has been either 2.1% or 2.2% for a year and a half, is happening because some of the unusual effects that pushed core CPI later are waning. Moreover, as I have written about expansively previously, housing inflation appears to have turned up but a more-substantial move higher is due (or perhaps overdue).

The CPI report and the adjustment to the market’s expectations about the next Fed Chairman are somewhat related. There is a notion out there – which I think is foolish – that the removal of Summers from consideration as the next Chairman, coupled with slightly weak recent data, lessens the chance that the “taper” will be announced this week. I do not think that either event bears on the probability that a taper will be announced. While I originally expected the taper to come later in the year than this, the voluminous statements of Fed Governors and Fed Presidents seems to indicate that it will begin imminently. The likelihood that a dove will take the Chairman’s seat does not change that. However, to the extent that the stock and bond markets rallied because they think a taper is less likely, a CPI print that takes core to 1.9% on the year will extinguish that frail hope. I think today’s stock market rally is subject to a near-term disappointment if this happens, and this is likely the case, although less so, for the bond market as well.

Verizon and Velocity

September 12, 2013 10 comments

What is the significance of the fact that Verizon on Wednesday managed to sell $49bln in bonds without any kind of hiccup?

Obviously, it means that the corporate market is doing okay, that investors who are starved for good spreads like the attractive spread the bonds were priced at, and that there is reasonable confidence in the marketplace that Verizon can succeed even as a much more-leveraged company. All are good things.

But here is another thing to think about. My friend Peter Tchir, who writes the excellent T-Report, noted this morning that “Investors weren’t selling other bonds to buy Verizon.” That is, a fair amount of the money may well have been coming out of cash to go into the Verizon bonds.

Why does this matter? Remember that the velocity of money is the inverse of the demand for real cash balances. That is, when everyone is holding cash, the velocity of money is low; when no one wants to hold cash, the velocity of money is high. I have shown the chart below  (source: Enduring Investments)  before and argued that higher interest rates will tend to increase velocity by decreasing the demand for real cash balances. At least, that usually is what happens.

velocity

What would a turn higher in velocity look like? Well, I think it may well look something like this. “I no longer have to reach as much for yield and take all the risk I had to in March to get a 3% yield. So it’s time to invest some of this cash.”

Now, the ultimate flows get a little confusing, because cash is neither created nor destroyed in this transaction. Cash is transferred to Verizon from investors; Verizon then transfers that to Vodafone investors, who perhaps put it back in the bank for no net change. But if those investors in turn say “I don’t want those cash balances, either,” and then go invest or lend it or spend it, then you’re starting to see how money velocity is increasing. The money essentially becomes a kind of financial “hot potato” now, moving more rapidly from investor to investor, from consumer to vendor, and so on. The volume of transactions rises, which increases prices and output as explained by the MV≡PQ monetarist credo.

And that is how higher rates can produce more inflation.

We are seeing other strange things, too, that could be consistent with this explanation. Another great blog, “Sober Look,” observed last week that 30-year jumbo mortgage loan rates have fallen below conforming mortgage loan rates. Their explanation of the phenomenon is worth reading, but note this part: “Flush with deposits, banks have access to extraordinarily cheap capital and are seeking to earn more interest income.” Yet this has been true for some time. What has changed is that interest rates are now higher, increasing the opportunity cost of cash in both nominal and real terms.

This doesn’t automatically mean that money velocity is increasing; it may just be an interesting bond sale and unusual market activity in jumbo mortgages. But it is worth thinking about, because as I note in that article linked to above, even a modest rise in money velocity could produce an aggressive response from inflation.

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