Monetary Policy for the Future

In a recent piece for the C.D.Howe Institute, Pierre Siklos points out that the velocity of money (roughly the number of times each dollar is spent on final goods and services each year) remained somewhat stable for a decade and a half while Canada  also had fairly stable prices and fairly stable interest rates. But things have changed recently:

Superficially, it appears somewhat puzzling that, despite large injections of liquidity, both inflation and expectations of inflation remain firmly anchored within the Bank of Canada’s inflation-target range [of 1-3%]. Since the fourth quarter of 2008, however, the velocity of money (i.e., the frequency with which money is spent or circulated in an economy), whose growth fluctuated around the zero mark for over a decade, has turned sharply negative with annualized growth rates of well over -10 percent. A return to higher velocity would, given a now much enlarged stock of money, herald higher inflation down the road.

Over the past two or three years, velocity has dropped, meaning the demand for money to hold has risen dramatically. This change occurred for two reasons.

• First, given the uncertainty about the future of the economy, the direction of aggregate demand, and the solvency of many financial institutions in the US, people would prefer to hold their wealth in money rather than other assets.
• Second, when interest rates are low, the opportunity costs (foregone interest income) of holding money are much lower. People opt to hold more money and fewer other financial assets.

These two explanations probably account for most of the drop in the velocity of money. Money doesn't turn over so fast because people hold more of it and hold it longer.

But with all the potential liquidity that is out there, the current situation is most likely an unstable equilibrium. As people regain even a smidgeon of confidence, and/or as people come to experience higher interest rates, and/or as people come to expect higher rates of inflation, we will not want to hold such humongous money balances.

And as we start converting our monetary assets into other assets, velocity will increase and so will aggregate demand. As Siklos and many others have warned, with all the liquidity already in the system, a rapidly increasing velocity will unleash gi-normous inflationary pressures in the next year or so. To head off the potential inflation, both the Fed and the Bank of Canada must be prepared to offset this rise in velocity by reducing the growth in liquidity or maybe even reducing the actual amount of liquidity.

Two questions arise from this analysis:

1. Do you think the monetary authorities can do it (or are even willing to try)? I think the odds are considerably higher that they can in Canada than in the US. If so, Canuck-buck denominated assets might be good investments (unless this effect has already been capitalized into the market, of course).
2. What's a good hedge against this type of potential inflation? What hedge has not already been capitalized into market prices?

Comments

[JH]

1) The Canadian monetary authorities would be quicker to act than their American counterparts, but the lags associated with any action would at the very best be 16 months. How long will it take people to change their expectations? If confidence is restored quickly and people start unloading their monetary assets on mass the Bank of Canada may not be able to stop the worst of the inflationary pressures.

If we can create a pre-emptive plan for buying up Government debt at the first sign of a turnaround we can likely reduce the jump in the growth rate of inflation.

2) I'm tempted to say gold, but it's already been bided up so high its lost its appeal. Maybe the best hedge is renegotiating your employment contract to factor in the expected jump in inflation. Or setting a renegotiation date in the future....

What about art? or collectables? A friend of mine so distrusted the banks he used to invest all his savings in WWII tank commander helmets! Some of which were worth over 15,000$.

[j]

2) none! what a silly question.