How Do We Count Money?
Milton Friedman postulated that MV = PT, where M is money supply, V is velocity, an PT is Price multiplied by Transactions (or GDP).
Mathematical transposition says V = GGP / Money.
This leads to the question: What is Money? Friedman thought it was M1 (essentially checking accounts but other mostly meaningless items).
Greenspan put a kibosh to that idea when he allowed banks to “sweep” money nightly from checking accounts to savings accounts. This distorted both M1 and M2.
Most economists use M2 as their measure of money.
What About Velocity?
Friedman made an error in his equation.
He assumed velocity was constant or at least relatively stable. Velocity is neither constant nor stable but it was relatively stable when he wrote MV = PT.
Some suggest Velocity is Milton Friedman’s Waterloo Battle.
Hoisington Management Fourth Quarter Review
Lacy Hunt frequently comments on velocity and does so again in his latest review.
Please consider the Hoisington Management Quarterly Review and Outlook Fourth Quarter 2022.
Other Deposit Liabilities
Lacy proposes using Other Deposit Liabilities (ODL) as a better measure of money.
The main difference between ODL and M2 is that ODL does not include currency or retail money market funds.
Currency is accepted at an increasingly fewer number of business establishments and simply cannot be used for very large sized transactions. Retail money market funds never became an important medium of exchange. Both are becoming a far less used medium of exchange.
ODL has the additional advantage that it is the main source of funding for bank loans and investments, making ODL both a monetary and credit aggregate. Friedman would not be surprised that the need to change the best definition of what constitutes money would change over the years.
Friedman’s Theory of Money and Inflation
Although Friedman’s monetary theory of inflation has justifiably drawn criticism, major components of his theory of interest rate cycles remain intact and the so-called flawed aspect can be overcome by converting money velocity (V) to an endogenous variable rather than assuming that V is stable. Once restated, the model applies very directly to the current interest rate outlook and suggests that even though the Fed is planning further increases in the federal funds rate in 2023, the direction of long-term U.S. Treasury rates is downward. In this letter, we will modify Friedman’s theory to incorporate an endogenous V and then apply the new model to the situation at hand as well as to the tumultuous events of the past three years. The determinants of velocity to be identified serve to reinforce the view that the U.S. Treasury bond market’s prospects are favorable even though conditions are very likely to remain volatile.
During Friedman’s career he first argued that M1 was the superior money measure then M2 and late in life he experimented with other definitions on the assumption that the velocity problem could be solved if money could be properly quantified.
Velocity is affected by cyclical, fundamental and idiosyncratic forces. While all are constantly at work, the evidence shows that two fundamental forces – the marginal revenue product of debt and the commercial bank loan to deposit ratio – are dominant over time.
ODL growth is estimated to have declined at a record 7.9% annual rate in the fourth quarter, following decreases at 2.7% and 1% annual rates in the prior two quarters. From the last quarter of 2021 to the same quarter in 2022, nominal ODL is estimated to have declined at record 2.8% annual rate, the largest yearly drop in history. In real terms, ODL also contracted at a record pace. Based upon the Fed’s monthly $96 billion balance sheet reduction and the monetary policy lags, the rate of ODL decline will accelerate in at least the first half of 2023. If the Fed sticks with its plan to raise the Federal Funds rate another 75 basis points, the rate of decrease in ODL will be sufficient to neutralize the money mountain of 2020/21 by the second quarter of 2023, when taking velocity into consideration.
Lacy’s Final Thoughts
The rise in velocity in 2022 is a stark example that V is determined by the actions of the private sector, not the Fed. This is the essential aspect of an endogenous variable.
If velocity had been stable in 2022, the Fed would very likely have come much closer to restoring their goal of a 2% rate of increase in core inflation. But the inability of the Fed to achieve their target quickly does not mean that they will be denied success. The planned actions are moving the Fed closer to realizing their inflation objective.
The risks of recession will become much clearer as 2023 progresses. Headline inflation will recede further from the 1.9% pace in the CPI of the latest six months. These developments are aligned with interest rate cycle theory as well as the case for lower U.S. Treasury bond yields.
Typo in the Hoisington Article
In the third quarter of 2022, all the growth in real GDP was accounted for by a reduction in net exports. This contributed to the sharp rise in third quarter ODL velocity.
I called Lacy and asked if he meant to say “reduction in net imports”. He laughed and said of the dozens of people who emailed him, no one else caught the error.
His original statement was along the lines of a “reduction in the net trade deficit” but somewhere along the way an editor removed the word “deficit”.
Recession Starts When?
Lacy to Me: When do you think recession started?
Mish: November or December.
Lacy: I think it started in November.
Mish: Can I quote you?
Lacy: OK Go ahead.
Bear in mind that I thought a recession started in May, but incoming data proved me wrong.
I never subscribed to the notion of a first quarter recession based on two consecutive quarters of declining GDP because Real Final Sales were positive for Q1 and Q2.
There was a negative turn in real retail sales in May but it did not stick.
The Final GDPNow Forecast for 2022 Q4, What Does It Say About Recession?
For discussion, please see The Final GDPNow Forecast for 2022 Q4, What Does It Say About Recession?
Lacy was not deterred by the Atlanta Fed forecast and neither was I.
Right now, the primary strength left in the economy is a reduction in consumer demand for goods. That reduction in demand reduced the trade deficit and thus added to GDP.
Some cite jobs as a strength but Lacy noted the declining work week. I caught that too.
Average Work Week Has Peaked and Total Aggregate Hours Is Rolling Over
The blue line is the average hours worked for all private workers. The red line is average weekly hours of production and nonsupervisory workers.
On January 11, I commented the Average Work Week Has Peaked and Total Aggregate Hours Is Rolling Over
Industrial Production
Lacy and I also discussed Industrial Production.
On January 18, I reported Signs Say Industrial Production Has Peaked and so a Recession is Imminent
Q&A IP and Recessions
Q: Why is IP signaling recession?
A: Because peaks in industrial production coincide with recessions.
Recession lead times vs industrial production tend to be very small, typically 1-2 months. 2001 and 2020 were notable exceptions.
NBER Recession Criteria
Neither Lacy nor I gets to call recessions. That task goes to the NBER. The NBER Q&A lists recession criteria.
Q: What indicators does the committee use to determine peak and trough dates?
A: The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real personal income less transfers (PILT), nonfarm payroll employment, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, employment as measured by the household survey, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions.
The only known positive (assuming you believe the data) is nonfarm payroll employment.
Real Disposable Personal Income Less Transfers is positive through November. But the BEA revised income lower earlier this year attributing to the recent bounce.
I expect more negative revisions to income. I also expect negative revisions to the payroll survey.
Industrial production appears to have peaked, real retail sales are declining, full time employment has been falling, and there is a huge discrepancy between the household and payroll surveys.
At economic turns there are lots of revisions. Heading into recessions, those revisions rate to be very negative.
True Contrarian View
Lacy mentioned that he recently gave a speech regarding recession timing. A key point he made went something like this. “People tell me a recession won’t start in 2023 because everyone expects one. I disagree.”
I replied, “A recession won’t start in 2023 because it’s already started. That’s the true contrarian position.”
Lacy laughed, saying “well stated”.
As noted above, neither Lacy nor I gets to decide when recessions start or end so we will have to wait and see.
Sure Is a Strange Non-Recession
Cast of Characters
- Mad Hatter: Jerome Powell, Fed Chair
- Red Queen: Janet Yellen, Treasury Secretary
- March Hare: John Kerry, U.S. Special Presidential Envoy for Climate
- Humpty Dumpty: President Biden
- Alice: You decide
In case you missed it, please see Alice Debates the Mad Hatter and the Red Queen on Timing the Recession
I go over jobs, industrial production, inflation and other indicators (including a swipe at climate change) in a humorous way.
Please give it a look.
This post originated at MishTalk.Com.
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from Vt – giving the income velocity economists false signposts.
The catallactic approach is more like: As Dr. Philip George
pointed out: “Changes in velocity have nothing to do with the speed at
which money moves from hand to hand but are entirely the result of movements
between demand deposits and other kinds of deposits.”
The Federal Reserve definitions of the money stock include
numerous items over which the Fed has little or no control (e.g., M2),
including many the Fed need not and should not control (currency). The
definitions also assume there are numerous degrees of “moneyness”, thus
confusing liquidity with money.
The definitions also ignore the fact that some liquid assets
(non-M1 components/ time deposits) have a direct one-to-one, relationship to
the volume of demand deposits (total checkable deposits, demand deposits),
while others affect only the velocity of DDs. The former requires direct
regulation; the latter simply is important data (on velocity), for the Fed to
use in regulating the money supply and thus aggregate monetary purchasing
power, AD.
See: “TOWARD A MORE MEANINGFUL STATISTICAL CONCEPT OF THE
MONEY SUPPLY” by Leland J. Pritchard March 1954 (Ph.D., Economics – Chicago
1933, M.S. Statistics – Syracuse)
No money stock figure standing alone is adequate as a guide
post for monetary policy. Aggregate demand, AD = M*Vt and not N-gDp as the
Keynesian economists define it.
Example: In 1978 (when Vt rose, but Vi fell) all economist’s
forecasts for inflation were drastically wrong.
Put into perspective: There were 27 price forecasts by
individuals & 9 by econometric models for the year 1978 (Business Week).
The lowest (Gary Schilling, White Weld), the highest, (Freund, NY, Stock Exch)
& (Sprinkel, Harris Trust & Sav.).
The range CPI, 4.9 – 6.5 percent. For the Econometric
models, low (Wharton, U. of Penn) 5.7%; high, 6.6% U. of Ga.). For 1978
inflation based upon the CPI figure was 9.018% [and Leland Prichard, in his
Money and Banking class, predicted 9%].
See: G.6 Debits and Deposit Turnover at Commercial Banks. When the g.6 release was discontinued in Sept. 1996 due to Clinton’s Paperwork Reduction act, it was then the longest running time series at the FED.
Deposit Velocity and Its Significance
(stlouisfed.org)
“Obviously, velocity of total deposits, including
time deposits, is considerably lower than that computed for demand deposits
alone. The precise difference between the two sets of ratios would depend on
the relative share of time deposits in the total as well as on the respective
turnover rates of the two types of deposits.”
the rapidity at which money is being spent in the economy (money physically
exchanging counterparties).
Whereas income velocity, Vi, is endogenously and
artificially contrived (N-gDp divided by M) whereas Vt, is an “independent” or
exogenous force (having “both magnitude and direction, making it a vector
quantity”), acting on prices.
What is being compared is the rate of change (ratio of the
absolute change relative to, divided by, the initial amount) in money flows,
not absolutes (difference between initial and final figures), or the relative
change sensitive to the denominator, and not the absolute change. A large
absolute change may not necessarily have a large relative change, and vice
versa. Thus, even if intermediate goods and used goods are exchanged, the
relative change in gDp is highly correlated.
equals the volume of means-of-payment money; (Vt), the transactions rate of
turnover of this money; (T), the volume of transactions units; & (P), the
average price of all transactions units.
impossible to calculate P & T in the equation. Nevertheless, the equation is a truism: to
sell 100 bushels of wheat (T) at $4 a bushel (P) requires the exchange of $400
(M) once, or $200 (Vt) twice, etc. Or a
dollar bill which turns over 5 times can do the same “work” as one five dollar
bill that turns over only once.
To the Keynesians, aggregate monetary demand is
nominal-GDP, the demand for services (human) and final goods. This concept
excludes the commonsense conclusion that the inflation process begins at the
beginning (with raw material prices and processing costs at all stages of
production) and continues through to the end.
all economic statistics, but that does not preclude us from using them. An
educated estimate is better than no estimate at all.
transmitting to worthy borrowers the savings of the bank’s customers.
R. Alton Gilbert (who wrote – “Requiem for Regulation Q:
What It Did and Why It Passed Away”), in his letter back to me on December 11,
1978:
“Such savings are invested in many ways, including deposits
at commercial banks.”
The differentiating question ostensibly illustrating the
pseudo economic reasoning is: How is the growth of bank held savings explained
in the consolidated balance sheet of the Federal Reserve System?
The answer is that it cannot be explained – because monetary
savings, from the standpoint of the banking system, is a function of the
velocity or rate of turnover of deposits, it is not a function of volume.
The growth of bank held savings thus results in no
alteration in the “footings” of the consolidated balance sheet.
Interest-bearing deposit growth signifies a transfer from demand deposits
either in the same institutions, or a transfer within the system, a bottling-up
of existing money.
And as long as monetary savings are held in the commercial
banks either in the form of demand or time deposits, the rate of turnover of
these deposits is zero.
The expiration of the FDIC’s unlimited transactions deposit
insurance is prima facie evidence.
unlimited transaction deposit insurance was reduced to $250,000:
Then we got the “taper tantrum” and subsequently
above average R-gDp and N-gDp growth rates by putting savings back to work (by
increasing money velocity). We got a sharp rise in the real rate of interest.
My forecast for a: “Zinger” – a surprise, shock,
or piece of electrifying news.
Open market operations should be divided into 2 separate
classes (#1) purchases from & sales to, the commercial banks; and (#2)
purchases from, and sales to, others than banks:
(#1) Transactions between the Reserve banks and the
commercial banks directly affect the volume of bank reserves without bringing
about any change in the money stock. The trading desk “credits the account of
the clearing bank used by the primary dealer from whom the security is
purchased”. This alteration in the assets of the commercial banks (the banks’
IBDDs), increases – by exactly the amount the PD’s government securities
portfolio was decreased.
(#2) Purchases and sales between the Reserve banks and
non-bank investors directly affect both bank reserves and the money stock.