The complexities of money –

Is the Fed easing enough in the current environment? This is not an easy question. Of course, the cost of credit from the Fed has been lowered and there is a TAF mechanism for lending but are these policy actions working? One method of looking at the effectiveness of monetary policy is through analyzing the money supply. Don’t forget that one of the big research issues concerning the Great Depression was whether there was enough money in the economy. Milton Friedman made his career on the argument that the Fed was not easing and the contraction of the money supply was the key cause for the depth and length of the Depression. If credit is not expanding we can look at it through the lens of monetary growth.

Unfortunately, the numbers do not provide a simple answer. In fact, the monetary aggregates show a very mixed picture. Some would argue that this mixed picture is a clear testimony for why money does not matter. I would argue that the confusion itself is sending some form of signal and we are required to develop an appropriate story for what may be driving the economy.

For example, a close look at the monetary base shows that there was a significant decline near the end of the year before the introduction of the TAF. The YOY change in monetary base has been in decline below 5% for a number of years. Surprising, M1 money supply has also shown flat growth since the fourth quarter of 2005. There have been other periods of negative growth which have been associated with the slowdown in 1996 and the recession in 2000. Broad money as measured by MZM has moved above double digits but this could be due more to a shift in portfolios. More money is moving into cash alternatives. Total debt has been growing at a faster rate than money. There is a strong argument from these numbers that money growth has not been as fast as financial growth which has been driven by leverage. The velocity of MZM money is showing a decline which is consistent with a cut in the growth of leverage will cause financial debt to move more in line with money growth

Consumer credit has been stable at around 5% since 2003. Nonfinancial commercial paper is still growing around 20% but the strong declines during the last recession suggest that there is plenty of leverage reduction to go with this credit slowdown.

One of the more interesting charts provided by the Monetary Trends publication of the St Louis Fed is the Taylor rule for the Fed funds rate associated with different inflation targets. We are now at rates which would be appropriate for 2% target inflation, but the Fed funds rate was just too low relative to even a 4% inflation target. If there is a lag between rates and inflation, we should not be surprised by the current environment. Using the McCallum rule for combining the monetary base growth and inflation targets, we are in the band that is associated with 2% inflation. There clearly is a breakdown in a number of monetary relationships.