Has the Fed's Exit Strategy Already Begun?

Yesterday morning on financial TV, someone (Larry Kudlow) asked "Should the Fed begin its exit strategy?"

Let me offer the view that it already has. The Fed's balance sheet ballooned last fall and peaked in December. Since then there has been no net new growth in total assets, but the composition of those assets have changed with circumstances. First, borrowing through special loan facilities grew rapidly, but the FOMC pretty much offset that by reduction in Treasury bills. The liquidity went where it was needed most without bloating liquidity throughout the system.

That special borrowing tapered off and has now diminished, but has been replaced with special assets such as commercial paper, mortgage backed securities, and consumer securitized debt, designed not to expand bank reserves and money but to unfreeze those markets and get them working again. Longer-term Treasuries have also been purchased to put downward pressure on longer-term interest rates, particularly mortgage rates.

People worry that purchasing longer-term Treasuries is "printing money" and is therefore particularly inflationary. Money is created when the Fed purchases assets, and it makes no difference in that regard whether it is long-term Treasuries, short-term treasury bills, or potatoes for the cafeteria. (Did I spell that right?)

While the total assets on the balance sheet first grew explosively and then flattened out, remarkably the growth of the M2 money supply has continued fairly steadily under the unusual circumstances. M2 growth has been faster than would be desirable under normal circumstances, but faster is appropriate when the velocity of the M2 measure of money has fallen. It's not money created that matters; it's money spent. Not money (M), but money times velocity (MV).

As confidence improves the velocity of money will presumably move back toward normal. It will not be difficult to see that and respond accordingly with slower money growth. Since gross domestic product equals money times velocity (GDP = MV) and since velocity equals GDP divided by money (V = GDP/M), a close eye on GDP growth is another way to see the need coming.

This is not rocket science.

Comments

[User 68966:]

The quality of the Fed's balance sheet is vitally important when it comes time to soak up all that extra $ in the system. Not sure how liquid the market is for potatoes from the cafeteria?

Aug 13 08:56 AM

[jockum:]

yes, who will buy? Nope, it will be adjusted with among other things, a higher price on mashed potatoes.

Aug 13 09:17 AM

[mavericks:]

Thank you for your commentary. I look forward to more here on SA as I have just become a follower of Bob McTeer...someone who has unparalleled insight into Fed actions.

I suggest all of you become followers too.

Aug 13 02:28 PM

[Johnc222:]

The U.S. Treasury should not be taking a divy from FRE....1.1 Billion would be far better kept at FRE for operational purposes.

The Treasury should convert those prefered shares to common, after all the Governemnt did not invest in these financials to make money but to support then through a Savage down turn in the Economy.

It's distasteful like taking money from a cripple person.

Time to convert to common.

Aug 13 03:15 PM

[Plant the s...:]

The risk with long term debt is the capital loss in a raising interest rate environment when the Fed is exiting the monetary stimulus. They could hold till maturity but that would limit their ability to slow money supply.

Oct 30 12:26 PM