Useful economics: MV = PQ

This is part of a series of three which will look at some useful economic frameworks for thinking about the current crisis. Today, I’ll look at MV = PQ and why it is useful in thinking about quantitative easing and the future course of inflation.

MV = PQ

M= money supply, V= the velocity of money, P=prices, Q=quantity of production or activity. PQ = nominal GDP

I don’t want to get into any theoretical arguments about this one, but it helps to explain the actions of central banks and why, eventually, they will end in inflation. The response of the Fed (and other central banks) to the seizing up of the banking system has been a rapid increase in money supply (and bank reserves) because they were worried about the velocity of money falling precipitately. They were correct about the velocity of money, which has collapsed. In essence this is QE, although the Fed has done its best to deny it.

However, no one really knows what would have happened had the money supply not been increased. The velocity of money, at least in the short run, appears to be inversely correlated with the supply of money. Despite this, it’s probably fair to say that the actions of the Fed and friends prevented nominal GDP (PQ) from falling more dramatically and that it stopped a debt liquidation spiral.

The problem now faced by the Fed is gauging when the velocity of money might increase. The first sign will be when banks are willing to resume lending and when the real economy shows some appetite to borrow. This is going to be difficult to judge and it is very likley that the Fed will get behind the curve, since it will want concrete evidence that animal spirits have returned to the economy. It won’t want to be accused of strangling a recovery, so it will be late to take action. Given the huge increase in monetary base, it won’t take much of an increase in the velocity of money to produce a significant dose of inflation.

The tools that the Fed can use to head this off are:

1. Increase bank reserve requirements.
2. Raise interest rates (including interest paid on bank reserves).
3. Sell assets from its balance sheet.

All of these pose problems. Bank reserves are very high at the moment because of risk aversion. The Fed controls reserves through open market operations and payment of interest on reserves rather than direct mandate. The Fed might want to think about following the Chinese example of a direct reserve requirement, which would be easier to implement than through market operations. The Fed will also be wary of a re-run of 1936/37, when it raised bank reserve requirments and caused a recession.

Raising interest rates again is not going to be an easy operation and you could see the potential for some (many) borrowers to get in trouble (again) and for those leveraged in some way to capital markets, playing the yield curve or carry trade, to hit the buffers quickly.

Selling assets from its balance sheet could cause significant dislocation and panic in bond markets. The Fed is now so heavily enmeshed in the private credit sector, that the exit strategy could be very difficult both logistically and politically.

So my feeling is that the Fed will be too late and too feeble with its actions to stem an increase in the velocity of money. I don’t know when this will happen. It is possible that, either through a trade war or risk aversion because the eurozone falls apart that there could be a period of deflation before inflation. If we saw a further deflationary pulse, then I think the Fed will pump up the money supply even more creating an even greater inflationary threat in the future.

Returning to MV=PQ, this little formula is not much use as a forecasting tool in terms of the exact level of each of the terms, but it is very useful in thinking how the variables interact and what might be the outcome of changes in the variables. For me, it makes me feel that at some stage we will get a significant pulse of inflation. Indeed, inflation is the only way that the overindebted West will be able to reduce its liabilities in real terms without a default. It also explains why I think deflation is highly likely in the short term in the eurozone periphery as the ECB refuses to act like the Fed.