The Federal Reserve and the Velocity of Money

Two phrases we’re hearing constantly are the Federal Reserve Bank is printing money, and flooding the market with liquidity is non-inflationary because banks are not lending. Typically the Fed increases the money supply by purchasing treasuries, putting more cash into circulation. Conversely, the Fed reduces or tightens the money supply by selling treasuries into the market. Until recently, the majority of the Fed’s assets were treasuries so there was little friction in the Fed’s open market operations.

The Fed’s ability to create money by purchasing assets is only limited by its balance sheet. Its balance sheet liabilities consist of bank reserves held on deposit and deposits from the Treasury. Recently the Treasury sold a substantial amount of debt for the purpose of depositing the proceeds at the Fed. This allowed the Fed to double its balance sheet to about $2T. The Fed is using this extra leverage to buy assets or loan on collateral with risks much higher than treasuries. Even though Chairman Bernanke says the Fed is taking an appropriate haircut and the Fed can sit on assets until they mature, these toxic and semi-toxic assets will be far more difficult to sell when the Fed needs to unwind its liabilities.

Velocity refers to the rate of turnover in the money supply. When the Fed injects cash into banks by purchasing assets, it expects the banks to start lending the money. If the banks simply hoard the cash, the multiplier effect is 1. However, with higher velocity the Fed’s impact is much greater, both with injections and tightenings.

Let’s look at how the multiplier effect works. All banks are required to keep a certain percentage of deposits on reserve at the Fed. This prevents an infinite multiplier. For example, if the reserve requirement is 10%, banks can lend out 90% of their deposits. Let’s say the Fed injects $100 into the money supply by buying treasuries from Bank A. Bank A then lends $90 to a business that deposits it in Bank B. Bank B then lends $81 to a consumer who writes checks which are deposited in Bank C. Then Bank C lends $72.90 which is deposited in another bank. Already the Fed’s $100 injection increased the money supply by $253.90. So far the multiplier is about 2.5. The Fed is claiming that the velocity is currently very low so its moves must be more dramatic.

Now the Fed is considering issuing its own debt to further lever up its balance sheet. This would require Congressional approval since the Fed is only allowed to issue currency. Could it be that the Treasury has reached its limit (debt ceiling) in pumping up the Fed? More interestingly, what would the effect be of such Fed borrowing? It could be sterile since the Fed is taking out as much cash as it is injecting. The net effect could be that the Fed is simply moving cash from a risk adverse lender to a higher risk borrower, while assuming the credit risk itself. An example would be a money market fund indirectly buying a credit card securitization via the Fed. The likely multiplier would be 1.

When we get the economic recovery everyone is praying for, the velocity of money will increase rapidly along with the money supply. This will bring substantial inflationary pressures. The Fed will not only have to remove the excess liquidity they provided, but a large multiple of it. The difficulty will be soaking up this excess liquidity by selling assets less desirable than treasuries.

Comments

[herbert hoover:]

Bernacke is operating the Federal Reserve like Bernie Madoff operated his fund. All Ponzi schemes end the same way.

2008 Dec 14 08:55 AM

[happysoul77777:]

The FAS 157 accounting rule scares investors and issuers. The securitization process is effectively dead for non-agency securities of mortgages, auto, credit card, and student loans. The multiplier is low for that reason. Banks actually are making loans. Please look at the bank data on the federalreserve.gov website to verify what I just said.

2008 Dec 14 02:28 PM

[Scalpulator:]

By buying debt the fed has helped to enable banks engage in more speculative activities with virtually no moral hazard. To imply this effect is non inflationary is deceptive and irresponsible at best.

The fed is desperate and the propaganda machine is turned up full blast. Please fasten seatbelts.

2008 Dec 14 04:28 PM

[jepittman:]

You are suggesting a moral equivalancy to a cheat and a fraud to the Federal Reserve. Your cynicism is appaling.


On Dec 14 08:55 AM Herbert Hoover wrote:

> Bernacke is operating the Federal Reserve like Bernie Madoff operated
> his fund. All Ponzi schemes end the same way.

2008 Dec 14 06:48 PM

[William Hum...:]

The Fed’s ability to increase the money supply is not limited by the size of its balance sheet. It automatically expands when it purchases securities in the open market, and contracts when it sells them. It can expand its balance sheet without limit if it so chooses. However under normal conditions, the Fed purchases securities only when the demand for bank reserves exceeds the supply at the Fed’s target Fed funds rate.

On the other hand, the size of the Fed’s balance sheet limits how much it can reduce the money supply by selling securities from its own portfolio. That limit depends on the market value of the securities it has available to sell. The recent sale of Treasury securities to the Fed substantially increased the amount of its available securities. The Fed sold them in the open market as needed to recapture most of the funds it created in buying toxic assets from various financial institutions.

2008 Dec 14 08:15 PM

[John Lounsbury:]

Excellent article. This deserves a much more vigorous comment stream.

to Herbert Hoover - - -

I understand one element of our monetary policy that you would relate to Ponzi: the expectation for future generations ("later investors") to pay for our consumption ("earlier investors"). However an essential element of a Ponzi scheme is deceit and lack of transparency. That is missing from the Fed equation. The Fed transactions are done in the open market.

2008 Dec 20 10:56 AM

[storm999:]

It seems to me regardless of the accounting mechanism, what is going on is that the banks are swapping illiquid securities for treasuries which can be used as collaterol in their derivatives contracts. Part of the credit crisis has been a demand for collaterol while bank assets are becoming illiquid.


There is a lot of name-calling going on, which is unhelpful. The monetarists need to chill a little.

2008 Dec 25 02:06 PM

[granger:]

What is the best means of tracking the velocity of money? is their a chart form/symbol?


On Dec 20 10:56 AM John Lounsbury wrote:

> Excellent article. This deserves a much more vigorous comment stream.
>
>
> to Herbert Hoover - - -
>
> I understand one element of our monetary policy that you would relate
> to Ponzi: the expectation for future generations ("later investors")
> to pay for our consumption ("earlier investors"). However an essential
> element of a Ponzi scheme is deceit and lack of transparency. That
> is missing from the Fed equation. The Fed transactions are done
> in the open market.

Mar 21 11:37 AM

[stojan nena...:]

Non-credit money ist the way for solving the world economic crisis.
Non-credit money is the necessary additional quantity of money in circulation (dM) as percentage (k) of existing quantity of money in circulation (M). dM = kM ; k = (supply - demand)/demand ;
If non-credit money is emitted according to the cited formula, inflation cannot exist. Also, taxes are annulled for the amount of non-credit money. The consumers pay less and producers get more than today, in the order of credit money. All get!

Jun 10 12:43 PM

[granger:]

How do we track the velocity of money? I know that the money supply was released last night, is there a measure in there?

Oct 02 06:09 AM