Sunday, December 7, 2008

"The Velocity Factor"

In John Mauldin's latest Thoughts from the Frontline newsletter, "The Velocity Factor" (PDF), Mauldin argues that the Federal Reserve "not really expanding the money supply, so far" because the expansionary effects of Federal Reserve actions so far have been offset, to a large extent, by the decrease in the velocity of money as financial innovations that increased velocity (e.g., securitization) are being unwound. Mauldin asks,

How much monetization will be enough to halt deflation and overcome the slowdown in the velocity of money and the rise in personal savings? No one knows. There is no fancy equation or model which can encompass all the factors, or at least not one I know of.

We will also soon see which of the additional deflation-fighting policies that Bernanke outlined in his 2002 "helicopter" speech the Fed will adopt. It is highly likely that we will see more than a few of them. It is quite possible that we will see the Fed start to set rates on longer-term bills and even bonds in an effort to pull down longer-term rates for corporations and individuals.

We will explore all the deflation-fighting options and what the results might be in future letters, but remember that there will come a time when the Fed will have to "take back" some of the liquidity they are going to provide. That means we could be in for a multi-year period of slow growth after we pull out of this recession. And this recession could easily last through 2009.

Here is a link to the 2002 "helicopter" speech by Ben Bernanke that Mauldin referred to above: "Deflation: Making Sure "It" Doesn't Happen Here".

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