The Fed's Next Move: Money Supply

While most of the business media is focusing on Lehman (LEH) and troubled financials, they are forgetting about this week’s Fed meetings and how monetary policy will respond to the crisis. After almost 6 months of shrinking real money supply (nominal money supply adjusted for inflation), Fed policy makers are going to decide whether to push the economy by once again increasing real money supply.

The last 6 months of shrinking real money supply has created a scarcity of funds that halted the drop in the value of the US dollar and deflated the commodity bubble. However, too few dollars also attenuated the credit crisis. Monetary policy didn’t cause Freddie (FRE) and Fannie’s (FNM) failure, Lehman’s (LEH) meltdown or Washington Mutual (WM) and AIG’s (AIG) problems. But the coincident timing of these failures is a result of 6 months of restrictive money supply causing investor risk premiums to increase and the weakest institutions being “closed” out of the market.

For the last year the Fed has been trying to walk the economy across a monetary policy tightrope and knows that if we lean too far one way or another the economy will fall and break.

As our journey across the monetary tightrope started, the Fed pushed us by injecting liquidity into the financial sector through its “emergency” facilities so that troubled banks, brokerages and insurers could work out their problems without hurting each other. Increasing money supply (i.e., lots of liquidity being pumped into the banks) and a falling Fed Funds Rate bought time for the banks and brokerage to raise capital and deleverage. But, by the middle of March, the dollar was tanking, commodity prices were beginning to spin out of control and the US risked triggering global runaway inflation.

Beginning in the spring of 2008, the Fed started to push the economy in the direction of a more restrained monetary policy. Money supply growth stopped and the Fed made it clear that they were done cutting the Fed Funds Rate. The US Dollar strengthened, the commodity bubble deflated but stress in the financial sector returned. 

Now the economy is looking into a black hole of uncontrolled banking failures, potentially shrinking money supply, deflation and wealth destruction. Because of the fragile, and potentially insolvent status of many financial companies, if the Fed is too restrictive it risks creating a “domino effect” of financial failures which will destroy money supply and cause a depression.  Many economists, such as Milton Friedman, have written extensively that the Great Depression could have been avoided if the Fed had focused on maintaining the amount of money supply as bank failures took place. Instead, during the Hoover Administration bank failures resulted in more bank failures and the financial sector deleveraged at an uncontrolled pace.  Money supply plummeted and by the time the Fed realized what had happened it couldn’t stop the damage.

As we move forward into 2009, if we fall off of the monetary tightrope on one side the economy is facing a deflationary cycle and a possible depression, and on the other side the economy is facing runaway inflation and a possible depression.  So it is important for the Fed to keep us on the tightrope and keep us from falling.  The Fed needs to increase money supply and cut the Fed Funds Rate, but not by too much.  On the other hand, the Fed needs to be an aggressive inflation fighter and keep monetary supply reasonably restrictive, but not by too much. 

The next move of the Fed will be to increase money supply which hopefully will have the effect of inflating (at least for a while) the banking sector. The Fed Funds Rate may be cut as well in an effort to pump operating profits into the banking sector.

For the week ending September 1, seasonally adjusted M2 (a broad based measure of money supply) remained essentially unchanged from the week ending March 24 and on a non-seasonally adjusted basis is actually lower than the week ending March 24.  This trend of no money supply growth will not continue for much longer, or the Fed risks repeating the mistakes of the Hoover era Fed.

Comments

[whidbey:]

Of course the money supply has been stable the Fed knows what lies in store for the economy when and if the housing markets continue to decay. The money required to stop the free fall of the housing sector, and with it the whole economy will be legendary to say the very least. The real bug-a-boo however is employment which currently threatens to grow at prodigious rates over the next six months. It is an out of control scenario which the Fed has little or no control over in either the short or long run. They are laying low until the they see the huns at the gates. It will not be long.

2008 Sep 15 10:00 AM

[Jason Rines...:]

Exactly Whidbey. I wrote in March of this year to the President, letting him know bank can and should fail, that firesales are the result of bad management, to let the foreign debt holders know we are serious we will repay them but that right now we should be focusing on energy independence and skilled job creation. With this lame House, waiting for to see if there puppet god gets elected, it is now too late to avoid depression. This will not unfold tomorrow however, it is a cumalitive effect. Nor will it be called a depression either, I expect more government manipulations of economic reporting. Just like this is the non-recession recession, the depression will be just simply called a recession. But true unemployment (those looking for work but can't find any) will be 15%-20%. Washington needs an enima but won't get one this election season, too many people 'hoping for change'. Neither political party can do much in the short or even mid term.

2008 Sep 15 11:28 AM

[HARM:]

<i>The Fed needs to increase money supply and cut the Fed Funds Rate, but not by too much.</i>

'Scuse me? The Fed "needs to" cut the FF rate again? It's already in negative territory when adjusted for inflation (regardless of which metric you use). Plus, they've just issued a check for $5 Trillion to teh GSEs, courtesy of the U.S. Taxpayer. Just how much more *accommodating* does the the Fed need to be? Perhaps Ben 'n Hank should just ask individual working-class taxpayers to drop their pants spread their a$$-cheeks so your well connected Wall Street buddies can have their way --without any added "inconvenience".

<i>On the other hand, the Fed needs to be an aggressive inflation fighter and keep monetary supply reasonably restrictive, but not by too much.</i>

LOL "reasonably restrictive" monetary supply, Fed as "aggressive inflation fighter"! Mark, you ought to do stand-up --that's your true calling.

2008 Sep 15 05:08 PM

[flow5:]

Money creating depository institutions do not loan out savings. Money creating depository institutions increase the money supply when they make loans to or buy securities from the non-bank public.

Savings held within the commercial banking system are lost to investment and to any type of expenditure. These deposits have a velocity of zero. These deposits can only be spent by their owners, they cannot be spent by the commercial banks.

Imposing interest rate ceilings & then lowering them until the CBs are out of the savings business does the following:

(1) it provides an immediate increase in the supply of loan funds
(2) it decreases the level of short & long term interest rates
(3) it vastly increases the profits of the commercial banks and the financial intermediaries
(4) it contributes to much higher rates of change in real-gdp

The proof? Take the housing crisis of 1966. Ceilings for CBs were lowered. There was an immediate increase in mortgage lending money. The housing crisis slowly recoverd, but slowly only because rates weren't lowered fast enough, and low enough.

If you don't understand this you have no idea how money & central banking works.

2008 Sep 16 06:34 PM

[flow5:]

Also, this can be accomplished by following a more restrictive monetary policy at the same time.

2008 Sep 16 06:35 PM