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11 Jun 2013
Flash: QE, the weak relationship between money growth and activity – Merrill Lynch BoA
FXstreet.com (London) - Michael S. Hanson, US economist for Merrill Lynch and BoA said the effectiveness of QE cannot be determined by the size of the Fed’s balance sheet or the growth rate of money.
He continued to say that the fact that the fastest growing sectors in the US during the current recovery have tended to be those that are most interest sensitive, including housing, autos, consumer durables and capex, suggests that QE has likely had some positive impact on the pace of growth.
He added that two other implications follow from the collapse in the money multipliers and the weak relationship between money growth and activity. First, he said, the Fed’s actions are not likely to lead to an increase in inflation unless inflation expectations become unanchored. And he explains, to date, if anything, inflation expectations have been edging lower, not trending higher despite QE1, 2 and now 3; Partly that reflects the deep recession and slow recovery that have kept inflationary pressures in check. But he suggests it also likely reflects the recognition that the Fed’s current balance sheet expansion ultimately will be temporary, although it may take some time to unwind. “Monetary theory tells us that it takes a permanent jump in the supply of money to get a permanent jump in the price level (with inflation in the interim adjustment), and a persistent, steady increase in the pace of money growth to get a persistent, steady increase in the inflation rate. The Fed’s exit strategy states that neither of these are planned, which appears to be credible to the markets so far given that inflation expectations have remained fairly stable”.
Second, as he explains, as the economy expands, the transaction demand for money should gradually return. “In other words, the traditional relationship between money growth and either real or nominal output appears to be one of reverse causation”.
He explains that although the direction of causality has been and likely will be debated for some time, in post-Volcker US data the correlation is highest between lagged income and future money growth. “So, while the current slow pace of money growth and collapsed money multipliers may not signal fundamental weakness in the recovery, they likely will rebound as the economy improves, with, perhaps, a long and variable lag”.
He continued to say that the fact that the fastest growing sectors in the US during the current recovery have tended to be those that are most interest sensitive, including housing, autos, consumer durables and capex, suggests that QE has likely had some positive impact on the pace of growth.
He added that two other implications follow from the collapse in the money multipliers and the weak relationship between money growth and activity. First, he said, the Fed’s actions are not likely to lead to an increase in inflation unless inflation expectations become unanchored. And he explains, to date, if anything, inflation expectations have been edging lower, not trending higher despite QE1, 2 and now 3; Partly that reflects the deep recession and slow recovery that have kept inflationary pressures in check. But he suggests it also likely reflects the recognition that the Fed’s current balance sheet expansion ultimately will be temporary, although it may take some time to unwind. “Monetary theory tells us that it takes a permanent jump in the supply of money to get a permanent jump in the price level (with inflation in the interim adjustment), and a persistent, steady increase in the pace of money growth to get a persistent, steady increase in the inflation rate. The Fed’s exit strategy states that neither of these are planned, which appears to be credible to the markets so far given that inflation expectations have remained fairly stable”.
Second, as he explains, as the economy expands, the transaction demand for money should gradually return. “In other words, the traditional relationship between money growth and either real or nominal output appears to be one of reverse causation”.
He explains that although the direction of causality has been and likely will be debated for some time, in post-Volcker US data the correlation is highest between lagged income and future money growth. “So, while the current slow pace of money growth and collapsed money multipliers may not signal fundamental weakness in the recovery, they likely will rebound as the economy improves, with, perhaps, a long and variable lag”.