Last week I wrote a piece that linked the increase in the Federal Reserve’s balance sheet to the most recent leg up in the stock market. I began reminiscing about the glory days of monetarism, an economic theory that was popular and widely taught in the 1970’s and ‘80’s but has since fallen out of favor.
Monetarism, which was largely associated with Nobel Laureate economist Milton Friedman, posited that GDP and inflation were primarily influenced by the money supply. A central tenet was the quantity theory of money, simplified as
(Money Supply) * (Velocity of Money) = (Prices of Goods and Services) * (Quantity of Goods and Services)
This theory did a wonderful job of explaining the inflation of the 1970s and the Federal Reserve’s efforts to control that inflation in the subsequent decade. Markets knew that the Fed was targeting monetary aggregates, which caused traders to wait breathlessly for the latest read on those key figures. After those decades, monetarism has yielded a track record that is mixed at best, causing it to fall out of favor. While I would hardly herald a return to many of the tenets that I learned at university, I do believe that there are valuable lessons that remain at least somewhat relevant to the current economic scene.
Chairman Bernanke showed the importance of stimulative monetary policy when he launched his programs of Quantitative Easing (QE) over a decade ago. The various rounds of QE are credited with improving the economy, though they had limited effect in reintroducing the levels of inflation that Mr. Bernanke and later Ms. Yellen had hoped for. From the larger economic standpoint, inflation – the change in “P” in the above equation – was largely offset by declines in the velocity of money – “V” in that equation. The velocity of money has been in a steady decline since the late ‘90s, and both its causes and effects remain the source of disagreement. I will argue though that there was indeed a huge inflationary effect: it was seen in the financial markets when the increased availability of money and credit boosted all sorts of asset prices.
Since the markets widely associate QE easing with rising asset prices, and since the new repo facility looks an awful lot like another round of QE – despite their numerous assertions that it is not QE4 – the latest increase in the Fed balance sheet should be attributed as a catalyst for the rising stock market. Although there is little reason to resume an obsession with the nuances of monetary aggregates, there is ample reason to scrutinize the changes in the Fed’s balance sheet when those statistics are released each week.
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