Friday, October 10, 2008

The 2008 Federal Reserve Tightening

Throughout the first half of 2008 most market commentators declared that the Federal Reserve was in an easing posture. In fact, with fed funds at 2 percent, many declared that they were in the process of contributing to the next inflationary binge.

Fed Funds are a Poor Indicator of Ease or Tightening

It is misleading to use the federal funds rate to judge the degree of Fed ease or tightening, or even whether they are easing or tightening. Why? Because, as I explain in the monograph I keep referring to, while the market is watching the fed apparently ease by lowering the funds rate, the Fed in reality is sometimes managing to reduce the level of reserves in the banking system at the same time.

To understand this, to even believe that it's possible, you have to understand the Strong Form of Monetary Theory that I've discussed in previous posts, and in the monograph. As I've explained, one of the best (though still not even close to 100% reliable) indicators of the true Fed policy is the trend in demand deposits balances.

Demand Deposits in 2008

If you go to the Federal Reserve's H.6 Release for August 28, 2008 and scroll down to Table 3 titled Seasonally Adjusted Components of M1 you can view the level of demand deposits on a weekly basis (seasonally adjusted) for the past year and a half. Note that in April of 2007 demand deposits were at $305.9bn and that by May of 2008 they had fallen to only $288.4bn. This occurred while the Fed was supposedly easing.

Was this merely one of those times when banks were finding ways to utilize deposits more efficiently, so that the system wasn't really contracting? Well, look at Currency on the same chart. It peaked at $761.5bn in October of 2007 and then stopped growing, or even fell modestly, until April of 2008. This never happens. Currency always grows at a fairly steady rate due to the past increases in the general price level, i.e., due to the public's need to catch up with past inflation. So, yes, monetary policy was tight for the last half of 2007 and the first half of 2008.

Confirming Evidence of Monetary Tightness

Note how the consumer expenditures in the GDP figures have started to be revised downward all the way back to the fourth quarter of 2007, revisions that are completely consistent with a monetary contraction beginning around the second quarter of 2007. Note also the reversal of the commodity bubbles around the world, the continuing fall in housing prices, and the steady rise in the stock market came to an end by the third quarter of 2007. All of this is consistent with a monetary contraction beginning in the second quarter of 2007, as explained in the monograph.

Finally, note the carnage in the stock market, the contraction of global credit and the sudden strengthening in the dollar over the past several weeks as the world's investors come to grips with the reality that we are deflating, rather than inflating.

Finally, an Easing of Policy, and What an Easing!

Now look at the current Federal Reserve H.6 report. Note that Demand Deposits, seasonally adjusted, have exploded in September, reaching just over $400bn in the September 29th week, an increase over trend of more than $100bn!

It's not a String the Fed is Pushing On; It's an Iron Bar

Again, you need to read the monograph to understand this. In any case, if you go to this link to the Federal Reserve's current H.3 Release and look at the Excess Reserves column in Table 1, you will see that after running just below $2bn for the entire year, excess reserves have now exploded to nearly $70bn in late September and to $136Bn in early October! This is exactly what has caused the huge increase in demand deposits.

If ever there was an economic environment where the "pushing on a string" theory would seem applicable, this would certainly be it. Yet demand deposit growth, i.e., money supply growth, has ballooned at a rate never before seen (though we came close at the turn of the century and also after the 9/11 terrorist attack.) It's not a string, it's more of an iron bar.

The Implications for the Markets

Suddenly we have a banking system awash in demand deposits, housing prices have already adjusted downwards significantly, the gas price surge that caused U.S. consumers to reduce other spending has reversed dramatically and stocks are at values not seen since the 1980 bear market.

In the meantime, Treasury Bonds are near all-time low yields offering only security, but certainly not yield, and we are about to enter an inflationary era not seen since the 1970's if the Fed stays on this course.

But how can stocks rally when there are no buyers, you ask? Well, it will probably happen when people holding long-term treasury bonds come to the conclusion that they're now holding the riskiest asset in the game and try to shift some of their assets to the stock market. After all, stocks are a far better long-term investment in an inflationary environment that are long-term bonds.

Next, I'll discuss how our inept government is on the verge of converting the extremely useful "iron bar" to that limp "string" everyone is always talking about. Really. That's what's in the works, and it's important that we understand the implications.

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