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.
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