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Fed Fumble: Lots of Cash, No One to Spend It

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Velocity of money has slowed to a crawl.

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With the Federal Reserve seemingly hell-bent on inflating its way out of this recession -- pumping an additional $1 trillion into the market -- the specter of hyperinflation necessarily looms large.

But not so fast: While the Fed's announcement might seem alarming, Chairman Ben Bernanke is fighting a forest fire with a water weenie.

Back in reality, the ongoing debt destruction and shift back toward savings is having a far greater effect on the American economy than a paltry few hundred billion dollars of "liquidity." The Wall Street Journal reports that, although M2 money supply has increased 10% in the past year, the cash isn't really going anywhere.

The more significant number -- what's known as the "velocity of money" -- fell to its lowest level since 1991. The velocity of money simply means how quickly money is spent: It measures the amount of gross domestic product, or GDP, generated for each dollar of cash sloshing around the system.

When confidence is high, credit is loose, and spenders are running rampant, money flows quickly through the system, boosting GDP. When social mood turns, however, and savers hoard their cash, the velocity of money slows down - and GDP grinds to a halt.

So even though the Fed is injecting more money into the system, consumers are socking it all away in savings accounts or paying down debt. Banks, for their part, aren't doing anything with the money, either. Big banks like Citigroup (C), Bank of America (BAC) and JPMorgan Chase (JPM), still reeling from mounting losses on bad debt, are hording what little cash they have.

Until the bad debt can be destroyed -- and until savers can receive attractive returns -- higher prices will remain merely hypothetical.

Inflation, like other economic entities, is controlled by supply and demand. The velocity of money is one way to represent the demand for "stuff" - when it goes up, prices tend to follow.

Fears about inflation are based partly on the assumption that, as consumer demand picks back up, empty store shelves and warehouses will create shortages that could lead to rampaging inflation.

Maybe - all in due time.

As the Journal points out, consumers jumping back into the spending game en masse depends on people not only having actual money to spend, but on having the desire to spend it. And while consumption certainly won't stop altogether, this slowdown may be something more than a run-of-the-mill recession: It may be a structural shift away from the consumerist leanings of the past 30 years.

Maybe, instead of stockpiling oil and gold, we should focus on stockpiling cash.
No positions in stocks mentioned.

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