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Money Supply and Economic Data Weekly Watch – The Fed’s Next Move Will Be To Increase Money Supply

While most of the busi­ness media is focus­ing on Lehman and trou­bled finan­cials, they are for­get­ting about next 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 and Fannie’s fail­ure, Lehman’s melt­down or Wash­ing­ton Mutual and AIG’s 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 liq­uidty 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 foward 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 Fed 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 agres­sive 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 24th and on a non-seasonally adjusted basis is actu­ally lower than the week end­ing March 24th.  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. 

Last week I was a guest on FOX Busi­ness Net­work dis­cussing the Fed’s next move and why. Take a look below at the segment.

[flv:911b.flv 325 255]

Posted in: CPI, Credit Crisis, Deflation, Economic Statistics, economy, Federal Funds Rate, Federal Reserve, Finance, FOX BUSINESS NETWORK, Hoover Adminstration, Inflation, M2, Milton Friedman, monetary policy, Money Supply

1 Comment

  1. Rob

    Nice, easy to under­stand piece (i.e., I for­warded it to my Mother). How­ever, it only addresses one part of the issue. All the cheap money in the world won’t get cap­i­tal back in the hands of end busi­nesses and the econ­omy, unless we find a way to re-establish con­fi­dence by lenders that asset val­ues and the entire econ­omy isn’t going to col­lapse. Re-establishing that con­fi­dence requires cred­i­ble, tough lead­er­ship from a bully pul­pit in Wash­ing­ton. Is it too late to draft Hillary?

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