MILLER’S MUSINGS: December 2008

A “Santa Claus” rally of stock prices has yet to appear, but I believe that Ben Bernanke and President-Elect Obama have nevertheless delivered a holiday present to investors.

The Federal Reserve’s chopping of interest rates will be only modestly helpful, but the real impact of the Fed’s recent actions is not via the mechanism of interest rates. Rather, it’s the promise of further substantial quantitative monetary expansion that, in my view, has taken “depression risk” off the table.

I was raised in the monetarist tradition in my training at the Fed and in graduate economics and finance courses, especially those taught by Karl Bopp (pronounced BOPE) and Ray Whittlesey at Penn in the early 1950’s. Reading and listening to Milton Friedman only reinforced my monetary bias.

Most students of economics used to be exposed early to the Quantity Theory of Money and the truism of the Equation of Exchange:

P=MV/T  or PT=MV

Where P is the price level, M is the money supply, V is the velocity or turnover rate of the money supply, and T is an index of the real value of the volume of transactions.

Most often, the Equation of Exchange has been used to explain the effect of changes in the money supply on the price level, specifically, that is, to explain inflation, i.e., the price level varies directly with the supply of money. Or as Milton Friedman said, “Inflation is always and everywhere a monetary phenomenon.”

But if we think of T as the potential full employment level of real GDP at any given moment, then we can see that an increase in M, unless offset by a decline of the velocity of money, would tend to raise T (real GDP) and not prices, as long as the economy is at less than full employment. Today, because of the huge slack in productive capacity that has appeared with the sharp fall in aggregate demand, worldwide, M growth should be reflected in a higher GDP.

The Fed began growing M very rapidly at the end of the summer and has continued to do so. Now we have their promise to continue to grow M as much and as long as needed to prevent further decline of economic activity. Inflation has been completely cast aside as a concern, at least for the next year or two.

The problem, of course, is not that the Fed has run out of ammunition as some have claimed after seeing close-to-zero interest rates. Far from it, if we look at substantial quantitative money creation and not just interest rates. Rather, the problem is that the velocity of money (V) is falling as the financial system and consumers continue to deleverage. As a result, the real economy has not yet felt the beneficial effects of monetary expansion. Given more time and further M creation, I’m convinced that will eventually happen.

But, eventually is not soon enough when we are seeing rapidly rising unemployment and GDP falling at an annual rate of over 5% (my forecast) for the current quarter. And that’s where our new President and his stimulus program come in.

Expenditure of $850 billion over two years is the early take on the stimulus. With current dollar GDP running at $14.4 trillion, that’s about 6% of GDP, or 3% of GDP for each year. That’s big. However, legislation must be passed, programs must be designed, priorities set, oversight put in place, all at the national level and then at the state and local levels. This can’t happen quickly.

But the very promise that it will happen will be a strong influence on planning and psychology.

The whole point of this short paper is not to say that our problems are behind us, or that we’ve seen the worst. We haven’t. The economy will continue to decline for two or three more quarters. Profits will be lousy and disappointing. Unemployment will grow and consumers will not quickly go shopping again. And we won’t return to the freewheeling, credit-hungry, highly leveraged economy of the past. The future economy will be significantly different in ways we don’t completely understand at this juncture.

BUT…….I believe that pessimism has reached “depression” proportions. And now I can see that a depression, fear of which is responsible for perhaps the last 15% or so of the stock market decline, is not in the cards. It’s time to begin moving slowly, carefully and deliberately out the risk curve. A “relief rally” of 20% or so may be ahead.

Happy Holidays!

pfmjr: 12/19/08

Warrent and Paul Miller


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