re: Fed keeps buying bonds at $85 billion monthly pace

I'm no expert and would like to get anyone's input on the following as background information.

One way of looking at GNP is GNP = Money Supply (M2) X Money Velocity (M2V).

GNP and M2 are calculated from observable data but M2V is indirectly calculated as M2V = GNP / M2.

(Stay with me, my head hurts too...)

Here is M2, Money Supply: Fed Data.



Here's M2V, Money Velocity: Fed Data.



Ok, here we go. Please jump in any time.

Inflation has two components, Money Supply and Money Velocity. You have to have both to create inflation. We can see from the graphs why we are having such low inflation currently. The Supply is there thanks to the QE, but the Velocity is at historically low levels. All that money has not gotten out of the banks. For those fans of Japanese deflation, this should look familiar.

Currently, the Fed has two main policies working: the Zero Interest Rate Policy (ZIRP) and the QE. The ZIRP is a standard tool of Central Banks, QE is not. QE is extraordinary. So it may be assumed that QE will be tapered down first, leaving the ZIRP in place longer.

But to avoid deflation, the Money Velocity must be increased. That means the Fed must make it more expensive for the banks to hold the money than to put it into circulation. This requires rate increases which will cause some inflation. But it depends on relative Money Supply. Just as we have no threats of inflation currently due to lack of Velocity, with the tapering of the QE funding, the Money Supply should drop, thus (hopefully) keeping inflation under the Fed's control.

This is too simplistic but it is food for thought. It could be a scenario that Chairman Ben thinks of when he drinks too much coffee. The current market? Well, The Herd is confused. As the previous poster allowed, good news is bad, bad news is good. But long run, this bull market has all the elements to continue until Velocity turns the corner and starts to increase.

Your thoughts / criticisms welcomed.