"Liquidity, velocity and stocks
The function of money is to facilitate exchange, and eliminate barter, thus speeding up, and expanding trade. The demand for money is increased by the following two conditions:
*Increase in productivity
*Increase in prices
The demand for money falls when the opposite conditions are operant:
*Fall in productivity
*Fall in prices
The Federal Reserve and Treasury have been increasing the volume of money within the system. Productivity has been falling, curtailed by falling demand for products & services that have excess capacity. The money supply has continued to grow.
Who are the recipients of the increased money supply? One of the rules of inflation is that the early recipients of new money, are allowed to buy assets with the new money thus essentially buying at a discount. The later you enter the chain, the greater the expropriation of your wealth that you will suffer.
The banks, auto-makers, and any other lame ducks that you can think of. Essentially anyone who was profilgate and stupid in combination.
What will they do with the new money? Hoarding will take place in some instances, but, many will buy assets with the money, to take advantage of a small window of opportunity of increased buying power that the new money affords.
Stocks have been rising, but the common concensus would seem to indicate that it is not Mutual Fund Managers, Pension Fund Managers etc who are driving the market. However, the banks have on aggregate, have been simply hoarding, rebuilding their capital ratios via Federal Reserve interest payments on said reserves.
Surplus money, or liquidity, needs to find a home. Rising asset prices, provide such a home. Rising prices remove liquidity, and by definition drive an increase in the demand for money.
The surplus money or liquidity, in pushing prices higher therefore eliminates the surplus supply of money, creating in time a deficit. A money deficit can be corrected through selling products/services.
What happens though when money is continuously pumped into the system? Prices will continue to rise. The Federal Reserve and other Central Banks, have not yet considered slowing the creation of new money, as, the economy, and particularly unemployment remain critical issues to their re-election, albeit, for Obama, 2.5yrs away.
Time will play a factor within the advent of an increase in liquidity and rising prices, as it takes time for the increased liquidity to leak out. Banks, as previously alluded, are not buying, rather, they are hoarding, rebuilding Balance Sheets.
Treasury paper, for psychological reasons, has been a recipient of much liquidity, although, with a failed auction last week, this asset class may well start leaking liquidity back into alternate assets. Banks, Pension Funds and Sovereign holders constitute major players.
China, is not happy. China has already made noises with regard to replacing the US dollar as the Reserve Currency. China will not be blind to the threat of increased liquidity within the Banks and what it must eventually mean. As a country in surplus, as opposed to a US deficit, China can withdraw liquidity, at no discount, due to US liquidity provision via Quantitative Easing, and reallocate this liquidity, [this holds true for Petro-dollars etc]
Where would this liquidity flow to?
The paradox of high inflation is that it can make stocks, claims on productive assets very cheap. Asia and South American inflations of recent times bear this out.
Although the official inflation rate is negligible, the creation of so much new money has created the potential of a serious inflation should it be released, highly possible."