The Fed’s Money Problems by Jes Black
May 6, 2003
forexnews.com
[inserted final line here since a genuine lulu]
Interestingly, the Fed has vowed to conquer the normal deflation cycle by further inflating the money supply and monetizing debt. Unfortunately, previous attempts have resulted in central banks destroying the currency first.
Meanwhile, students of economic history are selling the dollar.
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Today’s FOMC decision to shift its policy directive towards that of economic weakness highlights the central bank’s renewed concerns with the overall direction of the economy, irrespect with the recent rebound in equities or yesterday’s surprising pick up in the ISM services data.
The US has become a catch-22 economy. Rising government spending and a dozen rate cuts have failed to sufficiently stimulate the economy. Instead, they have led to soaring budget deficits and an over reliance on housing to keep the economy afloat. Meanwhile, as the President tries to get a larger tax cut passed through Congress, state and local governments are busy raising taxes to make up for their own revenue shortfalls.
But the greatest economic irony lies with the Fed, who despite an unlimited supply of dollars has money problems of its own.
The Fed’s dilemma can be seen best in the year on year change in M3 growth. After a meteoric rise from 1993-2002, even a 75% reduction in the Fed funds rate to1.25% has been unable to stimulate the same rate of credit creation, which began to contract on a relative basis since August 2002.
Herein lies the crux of the current funds paradox: The Fed’s money problems are not due to market uncertainty, but are instead a direct byproduct of its own easy money policy of the 1990s.
It should come as no surprise that increasing liquidity fuels assets markets. Principal to the great stock market boom and then bust was easy money and credit, which grew at an untenable rate under Greenspan’s second term. Plotted as year over year change, M3 grew twice as fast in this period compared to its historical average since World War II.
But conventional wisdom precludes economists from labeling this period as inflationary due to the common misinterpretation of inflation as rising prices for goods and services. Moreover, it is in periods of rising monetary inflation but falling CPI, which lead to the greatest accumulation of debt-fueled growth. Therefore, due to the lack of inflationary expectations, the large monetary stimulus in the 1990s instead found its way into rising stock prices -- the loftiest of which are now still under pressure. Equally, it can be argued that the latest round of rate cuts have only created a bond and housing bubble which may now need to deflate.
Failure to understand the underlying cause of booms and busts, which is an unsustainable increase then reduction in the supply of money and credits, is why the economy is not responding and why neither a tax cut, nor additional rate cut will have the desired stimulatory effect.
Looking back, the roaring 1990s were a manifestation of the Fed’s own irrational exuberance at fighting CPI, which was clearly under control after Fed Governor Volker tamed inflationary expectations in the late 1970s.
Not coincidently, the same happened in the early 1900s after an unsustainable increase in the supply of money and credit that resulted in a sharp rise in the general price level, followed by a decline in the rate of consumer price inflation. At that point, the Fed allowed credit to expand, which stimulated demand and led to business investment and higher profits. In turn the credit-fueled economic expansion led to a booming stock market and housing bubble, which eventually became unsustainable and crashed in 1929. The next ten years were spent working off the excess inventory while speculative fever diminished and allowed asset prices to revert to more normal levels.
Interestingly, the Fed has vowed to conquer the normal deflation cycle by further inflating the money supply and monetizing debt. Unfortunately, previous attempts have resulted in central banks destroying the currency first.
Meanwhile, students of economic history are selling the dollar.
(the Canucks suck) |
