Summary
U.S. inflation remains moribund as massive increases in monetary base have failed to flow through to real economy resulting in a collapse in the Velocity of Money and thus the potential for inflation.
Combination of fear and contradictory action by congress have led to build up of excess reserves of $2.25 trillion.
Excess reserves effectively sterilized by the Fed paying interest.
DJIA continues “cooking with gas”
Unintended Consequences of Glass Steagall Repeal
The repeal of the Glass Steagall Act in 1999 enabled banks to trade for their own account for the first time since the Act was introduced in 1933. This was the critical change to the entire banking system and the real birth of Transactional Banking. The nature of banking changed more towards trading for the banks own profit rather than lending money into the economy on a relationship basis, which creates jobs.
Following Lehman, quantitative easing by the Fed pushed the monetary base up five-fold from $0.8 trillion to $4 trillion. However, there was no commensurate rise in the GDP. It is, thus, little wonder that Money Velocity has collapsed.
Equation of Money Velocity:
MV = GDP/QM
MV = Money Velocity
GDP = Nominal Gross Domestic Product
QM = Monetary Base, M1, or M2
The rise of the numerator, GDP, in the equation has been swamped by the staggering jump in the denominator, whether that be the monetary base, M1 or M2. The net result is the drop in the velocity of money.
The rise in the monetary base, which would have historically moved into the economy under the old relationship banking method, has been diverted by the big money centre banks for the purpose of trading. Initially the recession reduced the demand for money at a time when the Fed was acting in desperation to re-liquefy the entire banking system.
As this was happening, fear and banking regulatory changes reduced the willingness and ability of banks to increase their lending. The fractional banking issue applies to lending but not to trading. Hence, money failed to flow into the real economy just at the time it was most needed.
