Everybody's watching the U.S. Federal Reserve Bank these days and speculating about what it's going to do. Given Bernanke's speech yesterday in Cambridge, markets now appear to be perceiving a still-dovish Fed.

But why is the Fed still so dovish? What are they worried about? Here's an interesting twist: Few people are talking about the complete collapse in money velocity, which is now at a five-decade low.

See the chart below:

Money velocity is one of those key metrics on the Fed dashboard. If the trillions in Fed stimulus were really working its way into the economy, or "Main Street," as it was designed to do, you would see an increase in the rate at which money moves through the economic system with lending, monetary transactions, and economic activity -- the measure known as Money Velocity.

When economic activity is high and at risk of overheating, such is in the late 1990s, the velocity of money is high, reflecting the fact that money is changing hands in transactions and banking activity. In fact, the opposite is now happening. As shown by the chart above, money velocity, as determined by the M1 and M2 measures, has collapsed. This may reflect the economic malaise that things are not as good as the financial markets appear to be telling us.

If you want a quick lesson on this, follow this awesome Khan Academy video.

With the velocity of money plummeting, it's clear that something in the fractional reserve banking system is broken -- the money remains trapped in the financial system.

Yet another indicator of this is the Fed's Money Multiplier, or an indicator of how the money injected into the banking system is multiplied by lending and economic activity. That's reached new lows recently, too, indicating that the fractional reserve system is not living up to expectations.

All of this is deflationary, not inflationary, and may explain why the trillions in Fed stimulus has not resulted in the massive inflation that has been predicted. This also explains why the Fed has remained so accomodative and reluctant to pull the stimulus, because of underlying deflationary forces.

This is great for Wall Street but not necessarily good for Main Street. It means that traders with access to large amounts of cheap trading capital can continue to make big bets as the Fed supports their access to capital -- but small businesses can't get that same access.

As Gloom, Doom, and Boom report publisher Marc Faber recently pointed out in Barron's, this means the rich get richer and the middle and lower classes continue to suffer.

"Money-printing boosts the economy of the people closest to the money flow," said Faber in the Barron's interview. "But it doesn't help the worker in Detroit, or the vast majority of the middle class. It leads to a widening wealth gap. The majority loses, and the minority wins."

Here's another problem for the Fed: Think of this stimulus/money supply as a reservoir, filling up with water. As you pump stimulus into the banking system, they improve their balance sheets and use carry trades to make money. After the financial debacle of 2008, the banks have been very conservative about shoring up their reserves and hoarding cash. But eventually, if you keep pumping and pumping more water into the reservoir, the dam will eventually overflow -- and that money will have to spill over into the real economy.

With unprecedented $3 trillion in monetary stimulus in the last few  years, it's clear the Fed can't be sure when this overflow will happen, or even what it might look like. When it starts to happen, it could happen very quickly, with unintended consequences, and the Fed will have to respond if inflation suddenly takes off.

This is why the Fed's decision about what to do about stimulus is so difficult. They've created themselves quite a trap.

This entry was posted on Thursday, July 11, 2013 at 14:23 pm and is filed under Macro, Investing.
Keywords: Inflation, Fed, Bernanke, economy, Money, Velocity

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