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This chart is very much worth a periodic review, since it illustrates the strong link between monetary policy and the health of the economy.

Note that prior to every recession since 1960, the real Fed funds rate (using the PCE Core deflator, the Fed's preferred measure of inflation) has risen substantially. In all but one case, the real funds rate exceeded 4% prior to every recession. The last recession was the only exception to that rule, since the real funds rate only rose to 3%. The level of the real funds rate is a good measure of how tight the Fed is; the higher the tighter. When real interest rates become very high, it is a sign that the Fed is restricting the flow of liquidity to the economy, and money becomes scarce and therefore very expensive to borrow. (They usually do this in response to a rise in inflation.) High real borrowing costs begin to snuff out risky initiatives, and increase the demand for money. People begin to prefer letting cash sit in money market funds rather than putting money at risk. Speculative activities become very expensive; it's more rewarding to own a bond than it is to be long gold or commodities. When enough of that happens, economic activity begins to weaken, and those with high debt burdens get crushed.

Also note that prior to every recession, the slope of the yield curve from 1 to 10 years was either flat or negative. A flat or inverted yield curve is a classic sign of tight money, because it is the bond market's way of saying that the Fed is so tight that it will almost certainly have to lower rates in the future. The combination of a high real funds rate and an inverted curve is thus an excellent sign that the Fed has put a big squeeze on the economy and a recession is thus very likely.

Today the situation is the exact opposite of a monetary squeeze. The real funds rate is almost as low as it's ever been, and it has been negative for more than 3 years now. This is typical of the early stages of a recovery. Recessions are provoked by a severe tightening of monetary policy, and once the economy has stalled the Fed reverses course and steps on the monetary gas. Their aim is to make money very cheap to borrow, and to weaken the demand for money. As the demand for money weakens, the velocity of money increases—people start spending the money they hoarded going into the recession, and this helps pull the economy out of its slump. We're now on the upslope of the monetary policy roller-coaster.

This recovery has been unusually slow to gain traction, and one reason is that the demand for money remains very high. M2 velocity has been very low (because money demand—the inverse of money velocity—has been very strong) since late 2008. Money demand has been so strong, in fact, that banks have been unwilling to use their mountain of reserves to make new loans, and the economy has been unwilling—in aggregate—to borrow more money, preferring instead to deleverage. Banks prefer to hold on to their reserve "cash" instead of spending it on new loans.

But this is not to say that the economy will be spinning its wheels forever. One thing we know almost for sure is that the economy is not suffering from a lack of liquidity right now, and liquidity shortages are what have precipitated every recession in the past. It would be highly unusual and surprising to see a double-dip recession any time soon.

What is more likely is that the economy will continue to grow, albeit slowly.

Why slowly? I have been arguing since early 2009 that we are suffering from a surfeit of stimulus. Fiscal policy is supposedly very stimulative, with federal spending having increased by fully 25% relative to the rest of the economy, generating gigantic deficits that have never been seen in postwar U.S. But excessive government spending coupled with increased regulatory burdens (e.g., Dodd-Frank) and huge deficits actually act to depress the economy in several ways. To begin with, when the government appropriates a big new chunk of economic activity by increasing its spending (and transfer payments), this wastes the economy's scarce resources and creates perverse incentives (e.g., by rewarding the idle and punishing the ones working hard). Second, new regulatory burdens dampen animal spirits by raising the cost of doing business. Third, huge deficits create the very rational expectation of huge new tax burdens, further increasing the cost of business. When you make businesses more costly to run, you should expect to see fewer new businesses. And when you increase tax rates on the margin, this reduces the reward to risk-taking and work, so you should expect to see fewer new businesses and fewer people offering their services to the labor market.

Furthermore, the hugely expansive position of the Federal Reserve—with its absolutely unprecedented and off-the-charts purchase of $1.6 trillion of government and agency debt—has most likely weakened the dollar and helped push up commodity prices. There remains great uncertainty about how and whether the Fed will be able to tighten policy in time to avoid an unpleasant rise in inflation—which is already on the rise. Monetary policy fears go a long way to explaining the strong speculative urges that have driven gold and commodity prices to new highs in recent years. And monetary uncertainty has undoubtedly contributed to dampen investor confidence in the future.

So to summarize: the chart at the top says we have every reason to expect the economy to continue to grow, but a surfeit of monetary and fiscal stimulus amounts to a significant headwind to growth. Memo to Washington: please stop the stimulus, it's really hurting!
Source: Stop the Stimulus, It's Hurting the Economy