"We risk becoming the best informed society that has ever died of ignorance"
- Rubén Blades

"You can't make up anything anymore. The world itself is a satire. All you're doing is recording it"
- Art Buchwald

"It's getting exciting now, two and one-half. Think of everything we've accomplished, man. Out these windows, we will view the collapse of financial history. One step closer to economic equilibrium"
- Tyler Durden

"It is your corrupt we claim. It is your evil that will be sought by us. With every breath, we shall hunt them down."
- Boondock Saints

Monday, July 25, 2011

Transitorily in Transition

The Federal Reserve’s Board of Governors has a monetary base measure that consists of currency and bank reserves.  Adjusted for reserve requirements, the BoG base measure offers a view at the nations total amount of currency.  In 2006 the total amount in circulation was 800 Billion.  Today is it just above 2.6 Trillion.  With this much money in circulation we better hope to have a robust economy because unless money is changing hands rapidly, then we have a stagnant economy, with lots of currency sitting around, doing nothing.

BoG Monetary Base, Adjusted for Reserve Requirements
BoG_Money_Base Adj_For_Reserve_Req_Changes

Velocity of money is defined simply as the rate at which money changes hands. If velocity is high, money is changing hands quickly, and a relatively small money supply can fund a relatively large amount of purchases. On the other hand, if velocity is low, then money is changing hands slowly, and it takes a much larger money supply to fund the same number of purchases.  This is where the US stands now.  Since the Fed did away with its M3 money supply to hide the injection of money given to the Plunge Protection Team to support the markets, we are left to use MZM instead of opting for M1 and/or M2.  For those who argue against PPT and say there is no way it could be hidden, I refer to the stories of Andrew MaGuire and Sunny Shue.
Velocity of Money and

It is not a secret that commodity prices are higher today than they were in 2008, by multiples in some cases.  If for some reason the US consumers took that 2.6 trillion in currency and began to exchange it more rapidly, the movement would spark demand increases, forcing money that was once ideal, into motion seeking an end product which is some commodity for our purposes.  This would drive prices higher as even more money begins to enter the market.  The demand for money is strong when the currency value is low and the demand is weak when the currency value is high.  Simply, if a good costs a $1 and the currency devalues, the good is now $2 and more currency is needed for the purchase.  If the $1 good goes to $0.50, then less currency is required to make the purchase, in this case half the currency.
CPI – All Items

One problem among a plethora the Fed faces will be how it can reduce the money base to increase the value of the currency, without pulling so much out that some people' can’t find that extra dollar to cover the spread from the cheapened notes.  If the Fed wants to sop up the extra money in the system it can raise rates.  To speed up the velocity of money being spent, it will offer negative nominal rates (rates below the rate of inflation, making TIPS note very appealing, yet still risky, especially if inflation is only “Transitory”). 
CPI - Commodities