The link between Fed actions and the economy is far more indirect and complex than the simple conclusion that Federal asset growth equals inflation. The price level and, in fact, real GDP are determined by the intersection of the aggregate demand (AD) and aggregate supply (AS) curves. Or, in economic parlance, for an increase in the Fed's balance sheet to boost the price level, the following conditions must be met:
The money multiplier must be flat or rising;
The velocity of money must be flat or rising; and
The AS or supply curve must be upward sloping.
The economy and price changes are moving downward because none of these conditions are currently being met; nor, in our judgment, are they likely to be met in the foreseeable future.
Aggregate demand (AD) is planned expenditures for GDP. As defined by the equation of exchange, GDP equals M2 multiplied by the velocity of money (V). M2 equals the monetary base (MB) multiplied by the money multiplier (m). Professors Brunner and Meltzer proved that m is determined by the currency, time, and Treasury deposit ratios, as well as the excess reserve ratio. The money multiplier moves inversely with the currency, Treasury deposit ratios, and excess reserve ratios and positively with the time deposit ratio. For example, if those ratios rise on balance, then m will decline. By algebraic substitution AD(GDP) = MB*V*m. In our present case, the massive increase in the Fed's balance sheet has created a sharp surge in excess reserves, and thus m has fallen.
Obviously the preceding paragraph is as clear as mud. It is included to provide mathematical proof of the complex connection between monetary actions and real world results. The practical and straightforward fact is that GDP has declined in the face of a surge in M2 growth. The labor market equivalent of GDP (aggregate hours worked) has declined at a record rate over the last 18 months, the entire span of the recession (Chart 2). That is, the monetary surge was totally offset by other factors; thus, the recession deepened and inflation was nonexistent.
The conventional wisdom is that the massive increase in excess reserves might eventually be used to make loans and reverse the economic contraction now underway, or that the velocity of money might increase. First, there is a very good explanation for the surge in excess reserves. The Fed now pays interest on its deposits, so banks have been incentivized to shift transaction deposits from riskier alternatives to the safety and liquidity offered by the Fed. Historically transaction deposits at the banks have fluctuated around 3% to 7% of a bank's balance sheet. In the second quarter, excess reserves averaged $800 billion which is 4.4% of the $18 trillion of bank debt (including off balance sheet). If this is the amount needed for transaction purposes, then this "high powered" money is not available for making loans and investments.
Second, velocity (V), or the turnover of money in the economy, is far more likely to fall than to rise. This is because V tends to fall when financial innovation reverses downward. As this process continues excess leverage will eventually diminish and together they will lead V lower. This process has already begun in the household sector.
In addition, the Fed needs an upward sloping supply curve to get the economic ball rolling. Today we estimate that the AS curve is flat. The reason it is in this perfectly elastic shape, rather than upward sloping, is that we have substantial excess labor and other productive resources. For example, in June the work week was at a record low while the U6 unemployment rate was at an all time high of 16.5%. No wonder wages are deflating. Further, industry capacity utilization was at a four decade low at 68.3%, while manufacturing capacity was at a six decade low for the longer running series at 65.0%. Indeed, when excess resources are extreme, the AS curve is likely to be not only horizontal, but shifting outward, meaning that prices will be lower at any level of aggregate demand or GDP. Thus, even if Fed actions could shift the aggregate demand curve outward, which it cannot do under present circumstances, inflation would still be a long way down the road. Thus, theory and current evidence clearly point to deflation as the overwhelming economic risk.
***********If I might add...China has 'strongly' hinted to the FED...They have until the end of October to stop devaluing the USD...I will locate the source as soon as I can ....8The Asian 'Hint' is based around the end of QE by end of October...
Are the Chinese still buying treasuries? I don’t think so. Japan is electing an opposition party into parliament. And the opposition party has publicly stated they will bailout of US treasuries and USD. Foreign creditors are bailing out of treasuries. They know what is coming. America’s IOUs are worthless. Soon, nobody will buy treasuries and the FedRes is running low on QE money having spent close to US$260 on QE thus far. China Daily reports :
China reduced its holdings of US Treasury debt in June by the biggest margin in nearly nine years, according to a US Treasury Department report issued on Monday.
China cut its net holdings by 3.1 percent to $776.4 billion in June from $801.5 billion in May, the report says. This is also the first large-scale reduction of US Treasury debt by China so far this year.
Reuters data show the drop in China’s Treasury holdings in June was the biggest percentage reduction since a 4.2 percent cut in October 2000. On the other hand, Japan, the second-largest holder of US Treasury securities, increased its holdings to $711.8 billion in June from $677.2 billion in May. America needs to borrow something like US$200B/month. On top of that the Feds need to absorb all the treasuries foreign creditors are selling. Bernanke has said he will extend QE till October of this year. But he will maintain the total amount of QE at US$300B. America is in trouble big time. How is the FedRes going to get out of this mess with just US$40B left to monetize treasuries? IMO, the FedRes will devalue the USD, this is the only way out.
America has something like US$250B worth of physical gold. By devaluing USD against gold ie revaluing gold price, everything will overnight be A OK! Say the FedRes declares that the US$150B worth of physical gold is now worth US$ 15T (ie 60x increase in gold price), straight away the FedRes is solvent. America’s debts will be whittled away overnight. America will now be solvent and will not need to borrow from foreigners any more! If you can accept it: We are just weeks away from a massive devaluation of the USD.