Money, Velocity, Price & Quantity

The Federal Reserve is in the process of buying up to $500 billion in mortgage-backed assets. Not exactly the “troubled assets” that the TARP was supposed to buy originally. These assets are backed by Fannie Mae (NYSE:FNM) and Freddie Mac (NYSE:FRE). Since Fannie and Freddie have effectively already been nationalized, it is almost like another form of government debt.

However, under normal circumstances the Fed only buys very short-term paper in conducting monetary policy. This paper will be of much longer maturity. It will also be more targeted towards the housing market, and should help to drive down mortgage rates.

How will the Fed pay for it? With the printing press, of course. The Fed is desperately trying to pump up the money supply (M). We are currently going through a big deleveraging, where everyone is trying to pay off debt and hold onto their cash as tightly as they can. This is true of corporations, individuals and most significantly banks.

This slows down the rate at which money turns over, or its velocity (V). One way of computing nominal GDP is the supply of money times how quickly it turns over, or M * V = P * Q, with P representing the price level and Q representing the quantity of output.

Thus, if V goes down, we will see either a fall in prices or a reduction in output. Right now we are seeing both, with a rapid decline in most measures of inflation and a rapidly slowing economy.

Therefore the Fed is trying to offset the decline in velocity with an increase in M, and is doing so at a very unprecedented rate. The monetary base typically grows by between 5 and 10% per year. Since 1959, the previous highest year-over-year change had been 16% in the run up to Y2K, and this was quickly reversed. It is now running a rate of over 75%, with virtually all of the increase coming in the last few months.

In August, the monetary base stood at $840 billion; by the end of November it was up to $1.44 Trillion. The process of buying these mortgage-backed securities will simply accelerate the process. This is a daring gamble on the part of the Fed, but most likely one that it needs to make,to prevent the total collapse of the economy.

However, if the economy starts to stabilize, the Fed will have to just as aggressively drain this liquidity out of the system. It will have to do so when the economic picture is at its bleakest (we are not there yet — not by a long shot). If it doesn’t, the risk of very high inflation (much higher than Ford/Carter levels) is huge.

I suspect that there will be a very rapid switch from deflation to high inflation, but that it will not occur until early 2010 at the soonest. When that happens, anyone holding long-term bonds, especially Treasuries will be decimated. Mining stocks, particularly of precious metals, like Newmont Mining (NYSE:NEM) and Barrick Gold (NYSE:ABX) will be huge winners in such a scenario.

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