How Do We Count Money?Milton Friedman postulated that MV = PT, where M is money supply, V is velocity, an PT is Price multiplied by Transactions (or GDP). Mathematical transposition says V = GGP / Money. This leads to the question: What is Money? Friedman thought it was M1 (essentially checking accounts but other mostly meaningless items). Greenspan put a kibosh to that idea when he allowed banks to “sweep” money nightly from checking accounts to savings accounts. This distorted both M1 and M2. Most economists use M2 as their measure of money.What About Velocity?Friedman made an error in his equation. He assumed velocity was constant or at least relatively stable. Velocity is neither constant nor stable but it was relatively stable when he wrote MV = PT.Some suggest Velocity is Milton Friedman’s Waterloo Battle.Hoisington Management Fourth Quarter ReviewLacy Hunt frequently comments on velocity and does so again in his latest review. Please consider the Hoisington Management Quarterly Review and Outlook Fourth Quarter 2022.Other Deposit Liabilities Lacy proposes using Other Deposit Liabilities (ODL) as a better measure of money. The main difference between ODL and M2 is that ODL does not include currency or retail money market funds. Currency is accepted at an increasingly fewer number of business establishments and simply cannot be used for very large sized transactions. Retail money market funds never became an important medium of exchange. Both are becoming a far less used medium of exchange. ODL has the additional advantage that it is the main source of funding for bank loans and investments, making ODL both a monetary and credit aggregate. Friedman would not be surprised that the need to change the best definition of what constitutes money would change over the years. Friedman’s Theory of Money and InflationAlthough Friedman’s monetary theory of inflation has justifiably drawn criticism, major components of his theory of interest rate cycles remain intact and the so-called flawed aspect can be overcome by converting money velocity (V) to an endogenous variable rather than assuming that V is stable. Once restated, the model applies very directly to the current interest rate outlook and suggests that even though the Fed is planning further increases in the federal funds rate in 2023, the direction of long-term U.S. Treasury rates is downward. In this letter, we will modify Friedman’s theory to incorporate an endogenous V and then apply the new model to the situation at hand as well as to the tumultuous events of the past three years. The determinants of velocity to be identified serve to reinforce the view that the U.S. Treasury bond market’s prospects are favorable even though conditions are very likely to remain volatile.During Friedman’s career he first argued that M1 was the superior money measure then M2 and late in life he experimented with other definitions on the assumption that the velocity problem could be solved if money could be properly quantified. Velocity is affected by cyclical, fundamental and idiosyncratic forces. While all are constantly at work, the evidence shows that two fundamental forces – the marginal revenue product of debt and the commercial bank loan to deposit ratio – are dominant over time. ODL growth is estimated to have declined at a record 7.9% annual rate in the fourth quarter, following decreases at 2.7% and 1% annual rates in the prior two quarters. From the last quarter of 2021 to the same quarter in 2022, nominal ODL is estimated to have declined at record 2.8% annual rate, the largest yearly drop in history. In real terms, ODL also contracted at a record pace. Based upon the Fed’s monthly $96 billion balance sheet reduction and the monetary policy lags, the rate of ODL decline will accelerate in at least the first half of 2023. If the Fed sticks with its plan to raise the Federal Funds rate another 75 basis points, the rate of decrease in ODL will be sufficient to neutralize the money mountain of 2020/21 by the second quarter of 2023, when taking velocity into consideration.Lacy’s Final ThoughtsThe rise in velocity in 2022 is a stark example that V is determined by the actions of the private sector, not the Fed. This is the essential aspect of an endogenous variable. If velocity had been stable in 2022, the Fed would very likely have come much closer to restoring their goal of a 2% rate of increase in core inflation. But the inability of the Fed to achieve their target quickly does not mean that they will be denied success. The planned actions are moving the Fed closer to realizing their inflation objective.The risks of recession will become much clearer as 2023 progresses. Headline inflation will recede further from the 1.9% pace in the CPI of the latest six months. These developments are aligned with interest rate cycle theory as well as the case for lower U.S. Treasury bond yields. Typo in the Hoisington ArticleIn the third quarter of 2022, all the growth in real GDP was accounted for by a reduction in net exports. This contributed to the sharp rise in third quarter ODL velocity. I called Lacy and asked if he meant to say “reduction in net imports”. He laughed and said of the dozens of people who emailed him, no one else caught the error.His original statement was along the lines of a “reduction in the net trade deficit” but somewhere along the way an editor removed the word “deficit”. Recession Starts When?Lacy to Me: When do you think recession started?Mish: November or December.Lacy: I think it started in November.Mish: Can I quote you?Lacy: OK Go ahead. Bear in mind that I thought a recession started in May, but incoming data proved me wrong. I never subscribed to the notion of a first quarter recession based on two consecutive quarters of declining GDP because Real Final Sales were positive for Q1 and Q2. There was a negative turn in real retail sales in May but it did not stick. The Final GDPNow Forecast for 2022 Q4, What Does It Say About Recession?GDPNow data from the Atlanta Fed, Chart by Mish. For discussion, please see The Final GDPNow Forecast for 2022 Q4, What Does It Say About Recession?Lacy was not deterred by the Atlanta Fed forecast and neither was I. Scroll to ContinueRight now, the primary strength left in the economy is a reduction in consumer demand for goods. That reduction in demand reduced the trade deficit and thus added to GDP.Some cite jobs as a strength but Lacy noted the declining work week. I caught that too.Average Work Week Has Peaked and Total Aggregate Hours Is Rolling OverData from BLS, chart by Mish The blue line is the average hours worked for all private workers. The red line is average weekly hours of production and nonsupervisory workers.On January 11, I commented the Average Work Week Has Peaked and Total Aggregate Hours Is Rolling OverIndustrial ProductionLacy and I also discussed Industrial Production. On January 18, I reported Signs Say Industrial Production Has Peaked and so a Recession is ImminentQ&A IP and RecessionsQ: Why is IP signaling recession?A: Because peaks in industrial production coincide with recessions. Recession lead times vs industrial production tend to be very small, typically 1-2 months. 2001 and 2020 were notable exceptions.NBER Recession CriteriaNeither Lacy nor I gets to call recessions. That task goes to the NBER. The NBER Q&A lists recession criteria. Q: What indicators does the committee use to determine peak and trough dates?A: The determination of the months of peaks and troughs is based on a range of monthly measures of aggregate real economic activity published by the federal statistical agencies. These include real personal income less transfers (PILT), nonfarm payroll employment, real personal consumption expenditures, wholesale-retail sales adjusted for price changes, employment as measured by the household survey, and industrial production. There is no fixed rule about what measures contribute information to the process or how they are weighted in our decisions.The only known positive (assuming you believe the data) is nonfarm payroll employment. Real Disposable Personal Income Less Transfers is positive through November. But the BEA revised income lower earlier this year attributing to the recent bounce. I expect more negative revisions to income. I also expect negative revisions to the payroll survey.Industrial production appears to have peaked, real retail sales are declining, full time employment has been falling, and there is a huge discrepancy between the household and payroll surveys. At economic turns there are lots of revisions. Heading into recessions, those revisions rate to be very negative. True Contrarian ViewLacy mentioned that he recently gave a speech regarding recession timing. A key point he made went something like this. “People tell me a recession won’t start in 2023 because everyone expects one. I disagree.”I replied, “A recession won’t start in 2023 because it’s already started. That’s the true contrarian position.” Lacy laughed, saying “well stated”. As noted above, neither Lacy nor I gets to decide when recessions start or end so we will have to wait and see.Sure Is a Strange Non-RecessionCast of CharactersMad Hatter: Jerome Powell, Fed ChairRed Queen: Janet Yellen, Treasury SecretaryMarch Hare: John Kerry, U.S. Special Presidential Envoy for ClimateHumpty Dumpty: President Biden Alice: You decide In case you missed it, please see Alice Debates the Mad Hatter and the Red Queen on Timing the RecessionI go over jobs, industrial production, inflation and other indicators (including a swipe at climate change) in a humorous way. Please give it a look.This post originated at MishTalk.Com.Thanks for Tuning In!Please Subscribe to MishTalk Email Alerts.Subscribers get an email alert of each post as they happen. Read the ones you like and you can unsubscribe at any time.If you have subscribed and do not get email alerts, please check your spam folder.Mish
