COVID Stimulus Checks & its Disparaging Impact

After accounting for inflation, the United States has currently allocated a greater amount of funds towards addressing the economic repercussions of the Coronavirus than it did for both world wars put together. This significant expenditure has led to certain imbalances in the economy that could have repercussions down the line. Indeed, a troubling development is unfolding in the global economy at present, which might emerge as a pivotal concern over the next twenty years, yet it is receiving little attention.

What exactly is the issue at hand? Essentially, the Federal Reserve Bank of the United States, along with various other central banks worldwide, are compelled to reclaim all the money they have been printing to support stimulus measures. The sudden increase in the Fed's Reverse Repos to $1 trillion has essentially undone over 8 months of quantitative easing efforts. While withdrawing cash from circulation is currently seen as beneficial (especially amidst concerns about hyperinflation), this could be seen as a temporary fix at best or a problem that will exacerbate in the future. To form your own conclusions on this matter, it's crucial to grasp a few key points. So, what are these Fed Reverse Repos that have economists worried? Why do some believe this could mitigate the risk of hyperinflation? And ultimately, how might this situation worsen everything, including inflation, in the long run? Now, Repos or "repurchase agreements" are essentially secure, short-term loans, often lasting just a day or two. For instance, if a company recently made a significant purchase but is short on cash to pay its employees, they can opt for a repurchase agreement with their bank. This agreement involves selling an asset to the bank at a lower price with a commitment to repurchase it later. While regular banks and central banks engage in similar transactions daily, the current concern lies with Reverse Repos, which operate in the opposite manner. Just like you can deposit money into your bank account for safekeeping, your bank can also keep money with The Fed for safekeeping through reverse repos. In this type of transaction, the bank buys assets from the Fed for cash, with an agreement that the Fed will repurchase the assets the next day at a slightly higher price. This premium is usually very small. For example, if J.P. Morgan were to buy a billion dollars' worth of assets from The Fed, they would only be able to sell them back for a $5,000 premium. While this might seem profitable for an individual, for a billion-dollar transaction, it's relatively insignificant. The term "overnight cash rate" refers to the fact that both Fed Repo (where private banks sell assets for cash) and reverse repo (where The Fed sells assets for cash) occur on one-day terms. This overnight cash rate is what The Federal Reserve Bank adjusts when it changes interest rates – specifically, the premium it receives or gives on these repurchase agreements.

Now that you have a grasp of what happens behind the scenes at The Fed, let's delve into why the recent increase in cash returning to The Fed is causing concern. The outbreak of the coronavirus led to significant economic uncertainty, with business closures, widespread unemployment, and operational challenges for companies. In response to this economic downturn, the Federal Reserve reduced its overnight cash rates from an effective annual rate of 2.50% to a mere 0.05% annual rate. This strategy mirrors the actions taken post the 2008 crash and during most economic downturns over the past five decades. The intention was to incentivize banks to lend more by offering cash at lower rates, which could then be passed on to consumers. Simultaneously, it discouraged banks from hoarding cash with the Fed due to the minimal returns on such deposits. The aim was to inject more money into the economy to boost spending and counteract the recession's impacts, a concept known as countercyclical monetary policy. However, the current approach seems to be ineffective. Despite the substantial funds generated for various stimulus programs to combat the pandemic, the money mostly remains digital in people's bank accounts rather than being circulated through loans or investments. Banks face limitations in utilizing these funds due to factors such as low interest rates on long-term loans, fluctuating demand for business loans, and reduced credit card usage. Moreover, banks are hesitant to invest in a booming stock market, as they aim to maintain a conservative investment approach with funds entrusted to them by businesses and individuals benefitting from unprecedented stimulus measures. While this situation may not bode well for financial institutions' quarterly profits, it raises questions about the overall impact.

It is possible for two reasons. Firstly, it indicates that the general confidence level among individuals in the economy is quite low. People across different economic backgrounds, from ordinary workers to major banks, are holding onto cash as much as possible, as a precaution. They are doing so in the event of losing their jobs, facing potential business closures, or encountering promising investment opportunities later on. The increased savings rate itself is not a major issue, but rather a signal that there may be some uncertainty about the future. The real concern lies in the fact that this surplus of money circulating could significantly restrict economic control. This concept is closely tied to what economists call The Velocity of Money.

In the case of hyperinflation, the risk of prolonged inflation was not significant due to the historically low velocity of money. To be fair, this is partly accurate. So, do the pessimistic economists have it wrong? Well, the velocity of money indicates how quickly money circulates, typically measured quarterly. For instance, if you spend a dollar at a local store, and that dollar is then used by an employee to buy an iced tea from a vending machine, the velocity of money for that quarter would be 2. This metric can be used to calculate GDP, where GDP equals the money supply multiplied by the velocity of money. Normally, the velocity of money ranges from 1.5 to 2 transactions per quarter. In the U.S., it has been declining in recent years, but it plummeted after the impact of the coronavirus. This decline was caused by two factors. Firstly, quantitative easing led to more cash in circulation, resulting in a lower proportion of transactions relative to the increased cash pool. Additionally, as previously mentioned, people are spending less due to fear, limited opportunities, or restrictions on spending. Consequently, individuals are holding onto their savings. However, this situation is not permanent. While the money supply will not decrease, people will eventually resume spending.

Let's revisit our equation. If the velocity of money is to return to a somewhat normal level, such as increasing from an average of 1 transaction per quarter to 1.5 transactions per quarter, this would imply that real GDP would need to grow by 50%, the money supply would have to decrease by 33%, or inflation would have to rise by 50%. Consider: Which outcome do you think is most probable?

Picture the economy as a balloon, with the air inside representing the money supply, and the bursting of the balloon symbolizing a Hyperinflation Armageddon. You can inflate the balloon with a lot of air, but if the air molecules are not moving quickly inside, you would need to add much more air than expected. Conversely, if you increase the speed of the air particles inside the balloon, it will expand and eventually burst, even without additional air. Alternatively, if you fill the balloon with air while it's cold and then let it heat up, it will burst. Economists are concerned that we are injecting the economy with "cold money" currently, but once things heat up and money starts circulating, we may face challenges we are unprepared for.

It is hoped that a blend of these three factors will occur gradually. Experiencing a 50% inflation rate within two years can be catastrophic, while the same rate over a span of 20 years is acceptable. However, it is essential to acknowledge that there has been a significant accumulation of potential resources. Dry powder, if mishandled, has the potential to cause unexpected consequences.