Curve flattening, quantity theory and transitory velocity

US long term yields are down, the 10 year yield after touching close to 1.70 two days back has come down by 15 bps to trade at 1.55. The other long term yields have also come down whereas the 2 year bond yield has moved to its one year highs of around 0.52. The curve is becoming flatter which essentially indicates that though the market expects the rate hike to happen in near term but the long term rates are going to remain low. As the rates in the economy are invariably linked to inflation (savers expect real positive rates), the long?term inflation is also expected to be subdued. Too early to say?but in case it is true then all the digital ink which myself?and other comment peddlers used to describe inflation and its hyper cousin, goes waste.?Again, too early to form any conclusion. Bond markets however remain the foundation for any other class as they decide the rates in the economy rest every market just follows suit.

Lets run a thought experiment here what happens in case all these inflation warnings turn out to be damp squib? It turns out exactly as the Fed and other Central banks have been explaining, i.e. transitory. All the supply bottlenecks solve themselves. So what lessons will be learnt and how universal those lessons would be. DM world especially US Fed and the incumbent govt would be logically justified in spending and creating more money. The basic premise of MMT as elucidated by Stephanie Kelton in her pathbreaking book The Deficit Myth is that no public welfare program should wait for allocation on the altar of balanced budget (Deficit is a myth, as the name of the book suggests). It is criminal to let people (US citizens) suffer without food and decent living when the govt can generate money by printing it. The only word of caution by her is inflation. in case it is moving up, go a little slow that's it. She makes the argument that if we can give the poor an allowance during a crisis, why not do the same in normal times. Why make him/her suffer because of a monetary/fiscal dogma which has been proven wrong. Just see the bond markets for a proof.

Now just think about the political implication of this thought process. No government can resist spending; spending on welfare, infrastructure, rocket launches etc generate good visuals and ensures reelection. Even if a rational reader finds the thought repulsive and against free market ideology, it hardly counts. Rather than regretting it we might do well to look for reasons for persistent low inflation. One attempt can be revisiting the quantity theory of money MV = PY. But before we dwell further a caveat here, the mathematically elegant equation is not equivalent to its cousins in the physical sciences like E = mc2 or F= ma. Economics is not a hard science and appearances are deceptive.

In case the equation is true, M represents money supply, V is the velocity of money, P is inflation or price changes and Y is real GDP growth. In an ideal world the velocity remains constant, you jack up the money supply and increase the growth. But at some indeterminate point of time the inflation will start increasing, at what point exactly no one knows. But take a look at the current scenario in DMs, the money supply is increasing but both the growth and inflation remain subdued. So what is happening, may be the assumption that the velocity is constant is not right.

Lets try to understand velocity a bit more, it is a measure of how quickly the money turns over. If someone spends a dollar and the recipient also spends it then the velocity is 2 because it was spent twice. If instead the dollar is put in the bank, the velocity is 0. It turns out that velocity is psychological, it all depends on how an individual feels about her economic prospects or how the consumers feel at the aggregate level. As the economic prospects dwindle, I will be cagey about spending and money will reach the savings bank account. Changing velocity presents a problem for the policy makers, so now apart from inflation characteristics they have to define velocity characteristics also. I will stop here, readers would do well to think that what happens in case the mood is euphoric and velocity starts going up quickly, keep an eye on the RHS of the equation.

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