The Fed and the Velocity of Money

Courtesy of Michael Steinberg, ClickBroker

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.