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

Jeremy Warner — We'll only know the economy is recovering when bond yields start rising again

You can see why everyone was so worried. The last time Britain was bailed out by the IMF in 1976, the primary structural deficit was "just" 4 per cent and national debt to GDP was by today's standards a very comfortable 53pc. Today's budget deficit is much higher, with overall debt expected to rise to nearly 80pc, according the last Office for Budget Responsibility forecasts. 

Even now, it's hard to fault the analysis, yet it misses a number of vitally important points. Most important of all, it's handy to have your own currency. This more or less eliminates default risk, if only because the government can simply print the money to honour its debts. And that's precisely what it has been doing with QE, depressing bond yields in the process. 

To the extent that there was capital flight, it has been countered by the Bank of England. These tools have not been available to eurozone periphery countries, which have in effect been borrowing in a foreign currency – the euro. For highly indebted nations, this raises the possibility of default from negligible to probable. 

Yet the analysis also reflects a fundamental misunderstanding of the nature of money, which I have to admit to fully grasping only quite recently myself. Interest rates as reflected in government bond prices are only a reflection of the level of economic activity. When the economy is growing strongly, money changes hands with high frequency, so there is a consequent demand for cash. To satisfy this demand for liquidity, money is withdrawn from bonds, which are in essence just cash locked up for a set period of time. The demand for cash reduces the demand for bonds, causing interest rates to rise. 

Conversely, in periods of low economic activity, such as right now, the velocity of money and therefore the demand for cash falls. Money instead gets parked in bonds, causing interest rates to fall. All this is just a complicated way of saying that when households and companies spend and invest less, they save more and money gets parked in bonds instead.

Read it at the Telegraph (UK)
We'll only know the economy is recovering when bond yields start rising again
Jeremy Warner | Assistant Editor

(h/t Andy Blatchford)

Another major commentator catches on.