The Failure Of Expansionary Monetary Policies

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Includes: GLD, SPY
by: Disruptive Investor

Summary

Money Velocity is at a 50-year low, indicating sluggish real business activity.

Expansionary monetary policies have done little beyond helping the financial system out of crisis.

Policy change and favorable business environment for infrastructure, manufacturing and small businesses is the need of the hour.

The asset markets are trading at record levels and there are discussions on how soon interest rates will start moving higher. There is no doubt that the expansionary monetary policies over the last six years have helped the banking and financial system to stabilize. However, it has done little beyond that as the real economy still seems to be struggling.

According to the Federal Reserve Bank of St. Louis, velocity of M2 money stock is defined as -

The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy. The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money.

The chart below gives the velocity of M2 money stock from 1960 to 2014.

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The velocity of money is at its lowest level in the last 50-years and a direct implication is that real economic activity is very sluggish. As M2 defines the transactions occurring between individuals in an economy, lower the number of transactions, the worse is the state of the real economy.

I have written in the past and I continue to believe that expansionary monetary policies have done little for individuals. The second chart below gives the US adjusted monetary base, which is currently at $4.1 trillion. Clearly, the monetary base has surged after the crisis on expansionary monetary policies.

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However, the key question is how much of the money has percolated into the real economy. Besides bailing out the banks and the financial system, low interest rates and expansionary monetary policies were intended to benefit business and individuals.

The third chart gives the excess reserves of depository institutions with the Federal Reserve. Excess reserves have swelled to $2.6 trillion and this surge has been in line with the surge in the monetary base. Therefore, banks have parked their excess cash with the Fed than increasing the credit growth. Certainly the banks are not to be blamed for this.

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Even consumers are more cautious on leverage. The bottom-line is that expansionary monetary policies have not done much for individuals or small businesses. The mortgage rates have declined, but that's also a part of the bailout and not a part of the recovery process.

I had earlier written an article on the discomforting factors related to the employment rate. If that reading is combined with this article, it is even clearer that expansionary monetary policies have done little for the real economy.

Just as the problem of leverage can't be solved with more leverage, the problem of over consumption can't be solved with more consumption. Along with expansionary monetary policies, the US economy needed policies that provide a boost to the aging infrastructure and policies that provide a boost to the dead manufacturing sector. The oil and gas sector has certainly been the bright spot, but it might not be enough to reduce the countries trade deficit significantly and also boost employment and economic activity significantly.

I wanted to write this article to conclude on an important point - Interest rate hike and the Fed tapering is likely to impact the asset markets and the financial sector more than the real economy consisting of individuals and small businesses.

Further, an interest rate hike or continued Fed tapering is also likely to have a minimal impact on asset markets. US equities might correct from overbought levels, but an interest rate hike will not be a trigger for a major market correction or crash.

The reason is that there is enough liquidity available in the financial system (not economic system) to support asset markets. Investors can therefore remain invested in the S&P (NYSEARCA:SPY) or consider exposure to the markets on a likely 10%-15% correction.

Also, I would likely to point out that deflation concerns will remain high in the eye of policymakers as long as money velocity does not pick up. I am bullish on gold (NYSEARCA:GLD), but the precious metal is likely to consolidate further at current levels before moving higher.

The bottom-line remains that Fed's expansionary monetary policies have done little for the real economy and have done a lot for the financial sector. It remains to be seen if the government brings forward more policies that create a favorable environment for the manufacturing, infrastructure and small businesses sector.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.