The Fed is back at it again; its pushing money supply as it tries to reinflate the economy. Money supply, as measured by seasonally adjusted M2, hit a new all time high of $7,870.4 billion and on a non-seasonally adjusted basis rose to $7,867.5 billion. However, because the global economy is stuck in a liquidity trap, the Fed’s stimulus isn’t having much of an effect. But, sooner or later the liquidity trap will clear and all of the monetary stimulus will suddenly create a liquidity bubble. Unless the Fed can pull a really big rabbit out of its monetary hat, they are setting the economy up for new asset bubble and problems in 2009 and 2010.
A liquidity trap exists when interest rates are at or close to 0% and monetary policy is no longer having a stimulative effect. The cure for a liquidity trap is fiscal stimulus and not continued expansion of the monetary base. Right now the economy’s issue isn’t a shortage of money but rather the hoarding of cash by credit intermediaries and a drop in the velocity of money. Falling velocity means a decrease in the speed at which money turns over and is spent and respent. When money is hoarded and velocity goes down it feels to the economy just like money supply is dropping. The result is deflation, recession and indiscriminant credit rationing. So while it feels like money supply is too small, the real problem is that the turnover rate of money has fallen.
I don’t understand why the Federal Reserve is pushing an increased money supply when we are in the middle of a liquidity trap. Right now more money will only result in more hoarding. I understand why the Federal Reserve needs to make sure that money supply doesn’t fall, but dramatic increases in money supply aren’t going to help. Increasing money supply doesn’t address the fall off in velocity and it doesn’t unclog the liquidity trap.
Fiscal stimulus is a cure for a liquidity trap. The government sector can, by itself, increase velocity through increased spending. And, sooner or later, fiscal stimulus will get the global economy moving again. But, because of current Federal Reserve actions, when the economy starts to expand, money supply will be elevated and an asset bubble and inflation will result.
TARP is a form of fiscal stimulus and once the money from TARP starts to flow the turnover rate of money will accelerate. After the election I also expect an additional fiscal stimulus package to make its way through Congress and that will also have a stimulative effect on the economy and velocity.
Other economic data
There is no good news in the other economic data. Unemployment is heading up and the Grinch is going to steal Christmas. Until the effects of TARP are felt and the Government settles on a new fiscal stimulus package don’t look for things to get a lot better.