Yi Wen and Maria A. Arias — What Does Money Velocity Tell Us about Low Inflation in the U.S.?

Holy moly. Still thinking in terms of Friedman's quantity theory. So they confuse the causality.

So why did the monetary base increase not cause a proportionate increase in either the general price level or GDP? The answer lies in the private sector’s dramatic increase in their willingness to hoard money instead of spend it. Such an unprecedented increase in money demand has slowed down the velocity of money, as the figure below shows.

And why then would people suddenly decide to hoard money instead of spend it? A possible answer lies in the combination of two issues: 

A glooming economy after the financial crisis
The dramatic decrease in interest rates that has forced investors to readjust their portfolios toward liquid money and away from interest-bearing assets such as government bonds. 

In this regard, the unconventional monetary policy has reinforced the recession by stimulating the private sector’s money demand through pursuing an excessively low interest rate policy (i.e., the zero-interest rate policy). 

The increase in the monetary base did not cause people to hoard money and thereby reduce velocity, nor did historically low interest rates. Increased liquidity preference in the case of uncertainty and the need to deleverage, together with tighter lending standards (locking the barn door after the horses have escaped), resulted in higher than usual saving desire relative to spending desire for consumption, and also investment to some degree. Decreased domestic demand also sent a signal to firms not to invest in expanding production domestically. 

A question remains why firms did not invest in capital expansion? Actually, many did, but in FDI where prospects appear brighter than in the US. A significant of increasing corporate earnings also went to either corporate savings or stock buybacks to drive up the share price rather than to increasing dividends, whence it might be spent domestically.

Low interest rates and QE deprived the domestic economic of demand resulting from the interest that would have been paid without QE and reduced the amount than was paid at the low rates relative to more normal rates. But it's a stretch to say that low rates were the cause of money hoarding. In fact, the low rates drove prices of riskier assets higher than they would have been otherwise, as the Fed itself admits and said was a policy objective to increase the wealth effect in addition to stabilizing the housing market by keeping mortgage rates low than they would otherwise be.

The authors conclude:

This happened because the nominal interest rate on short-term bonds has declined essentially to zero, and, in this case, the best form of risk-free liquid asset is no longer the short-term government bonds, but money.

The authors are obviously neither wealthy nor in business or they would know that when large sums are involved even a very small return is significant. When there is a choice between the two alternative of essentially the same risk and one pays some interest at a similar degree of liquidity, however small, and the other does not, then the former is the rational choice and will be chosen by rational agents.

The fact is that the Fed chose to pay interest on excess reserves when it initiated QE in order to maintain control of the interest rate and set it slightly above zero.

FRBSL — On the Economy

What Does Money Velocity Tell Us about Low Inflation in the U.S.? [short]
Yi Wen, Assistant Vice President and Economist, and Maria A. Arias, Research Associate