Monetary Policy

Oct 1st 2013

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This empirical study examines the effectiveness of monetary policy as a counter-cyclical instrument.
The research analyzes data and interaction of the key monetary variables over the last 50 years:
Money supply, money velocity, interest rates, yields, hoarding behavior and their effects on GDP growth.
The empirical evidence leads to following unconventional conclusions:
The full report under the link below includes the empirical evidence, methods, charts, references
as well as the comprehensive data-set.

1. Expansion of the money  supply has no significant effect on GDP growth

The relation between expansion of the money supply and GDP growth proves extremely weak.
Single correlations illustrate the absence of significant growth effect :


Research into the sequential effect of monetary expansion by means of multiple regression (OLS)  provides the evidence that the GDP growth attributable to expansion of the money supply is negligible and restricted to one quarter following the inflation.  The minute growth effect is short lived and entirely evaporates after one quarter to be followed by a significant growth contraction three quarters later.

2. Monetary expansion is disabled by a simultaneous decline of money velocity

Sometimes people tend to hoard substantially larger amounts of cash reserves. And so do banks. Higher hoarding levels by definition result in a decline of the velocity of the money in circulation. Over the last 50 years velocity of MZM money ranged between 1.4 and 3.5. The fluctuations of money velocity thereby follow a remarkably inverse pattern with the money supply.


The monetary expansion is neutralised largely by the simultaneous decline of money velocity  The coincidence of money stock inflation and the decline of the money velocity is indeed surprisingly strong (Correlation: R²=0.64; Sig=1.3E-46).   As a consequence and contrary to monetarist belief, inflating the money supply does not systemically result in increased spending or in output growth.


3. Low interest Rates stimulate hoarding behaviour and weaken aggregate demand.
Interest rate suppression consequently  is counterproductive as a anti-cyclical instrument.

The lower the opportunity cost of foregone yield, the more people (and banks) hoard cash reserves and the more money velocity declines. The charts of the Federal Reserve below illustrate the correlation and coincidence of money velocity and  the interest rate level.


Chart 1: Velocity of MZM Money 1962-2013

Chart 2: One Year Treasury Yield 1962-2013

Chart 3: Ten Year Treasury Yield 1962-2013

Data Source: Federal Reserve of St Louis

Counterproductive Monetary Policy,
inspired by False Keynesian Assumptions.

Keynesian theory holds that hoarding levels and business cycles are steered by waves of optimism and pessimism, fuelled by highly irrational emotions of fear and greed. Keynes’ empathic “animal spirits” assumption continues to inspire monetary policy worldwide.

Still fifty years of monetary data provide the evidence that the Keynesian assumption is false. Individual emotions of fear and greed prove too aleatory to provoke collective mood changes. Monetary data do indeed demonstrate that, rather than by Keynesian emotions, hoarding behaviour is steered by the interest rate level.

The lower the opportunity cost of foregone yield, the more people (and banks) hoard cash reserves and the more money velocity declines. Hoarding levels prove indeed highly correlated with the yield level.

The correlation between money stock inflation and the decline of the money velocity is remarkably strong (correlation: R²=0.64; elasticity = - 0.75). As a consequence and contrary to monetarist belief, inflating the money stock does not automatically translate in effective spending and output growth as the monetary expansion is neutralised almost entirely by the simultaneous decline of the money velocity. Most of the cash injected in the economy is neither spent nor lent but hoarded.

Chart 4: Correlation Money Velocity and  
 10-Year treasury Yield 1962-2012

The crucial issue is that interest rate suppression proves counterproductive with devastating deflationary effects as a result:

  • Low yields obviously tend to stimulate hoarding depressing aggregate demand even more.
  • Manipulating the “price of credit” unbalances supply and demand for loans. Low interest rates  have besides the intended effect of boosting demand for credit also the effect of depressing the supply. The lenders’ eagerness grant loans declines along with declining rates and margins. The lower interest rates, the higher the likelihood of subsequent rate hikes and the lower the banker’s eagerness to engage in (long term) lending .
  • Rate suppression provokes a systemic mismatch between durations of the loans needed and the loans on offer. The lenders’ inclination to shorten credit durations during rate cuts is not matched by a corresponding shift of investment projects in the real economy. Confronted with the scarcity of appropriate long-term credit, long-term investors face a dilemma. Either they freeze their planned investments or they compromise their financial stability by agreeing to loan durations that are incompatible with the long term nature of their project. On the macro-level, the likely outcome is a devastating mix of both. The housing debacle was a typical example of the last.
  • Artificially low interest rates tend to over-stimulate long-term investments to the detriment of short-term projects. The resulting misallocation of resources is incompatible with people’s time preference and the actual needs of the real economy. The distortion leads to misadventures and massive loss of resources and utility.
  • The borrower’s gain merely is the lender’s loss. Besides the intended reduction of the borrower’s loan burden, rate suppression also causes the lenders’ income to drop to the same extent, leaving no net gain for the economy as a whole. Savers, insurance trusts, investment funds, retirees etc. thereby see their spending power structurally impaired. The lower yields, the more pension reserves need to be provisioned and the less cash remains available for immediate spending.

The full report under the link below includes the empirical evidence, methods, charts, references
as well as the comprehensive data-set.


Chart 1: Monetary Base


In an aggressive response to the credit crisis, the Federal Reserve successively launched QE1, QE2, QE3 and QE4. In their fruitless effort to boost demand and lending the FED inflated the monetary base to absurd proportions. The monetary base rose by no less than 400% since 2008.


Chart 2: FED’s Mortgage-backed securities

The composition of the Federal Reserve's balance sheet shifted dramatically since 2009, when asset purchases took the form of purchases of long term Treasuries and mortgage-backed securities. The quality and liquidity of both the FED and the ECB’s assets have critically deteriorated in the last couple of years. Highly illiquid long term mortgage backed securities already stand for one third of the FED’s assets. On the ECB’s balance sheet low graded PIIGS debt has progressively replaced AAA securities.


Chart 3: FED’s Long term securities


During “Operation Twist” the FED replaced the usual short term treasuries by Long term securities. With yields at historical lows, finding a ready buyer for long term bonds could prove problematic in a rising rate environment.


Chart 4: FED’s Short term treasuries

The Fed no longer has any treasuries maturing in less than 90 days.

Source: Federal Reserve of St Louis


Also read:   Lessons from the Euro Crisis (US House of Representatives Joint Economic Committee)

The Sovereighn Debt crisis (Roubini) (audio-mp3)
Public Debt: The smooth path to slow growth and Sovereign Failure
Europe's sovereign-debt crisis (The Economist)
Why Greece is not out of the woods yet (Peterson Institute)
Teaching PIIGS to Fly - Roubini about Greece’s fiscal problems
Should Germany foot the bill for Greece? Political Tensions over Debt (Deutsche Welle)
The Euro Currency Crisis- The fundamental flaws of the Euro
Japan’s Slow-Motion Crisis by Kenneth Rogoff

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