The 5 ¾% Solution
by Charles Mackay, Thursday February 17 2005
wallstreetexaminer.com
"So it is written, so it shall be done." That’s what the Great Pharaoh in the movie the Ten Commandments told his subjects when he made an important decision regarding his kingdom. And so it was written Wednesday by the Fed – we will have 5 ¾% economic growth in 2005, which includes 1 ¾% core inflation.
First a little explanation of the Fed’s report, Monetary Report to Congress. The Fed, for the first time Wednesday, presented a detailed two year economic projection. Previously the Fed only looked ahead one year at a time. Using a concept pioneered by Alan Greenspan himself, while he was an economic advisor to the White House in the early 1980s, the Fed incorporates the use of ‘core’ inflation in its report. Specifically, the Fed’s concept of core inflation refers to the core Personal Consumption Expenditure index that comes from the Department of Commerce. The PCE index is an implicit price deflator for personal consumption expenditures used to compute GDP, with the core amount being less food and energy. In 2003 and 2004 respectively, the core PCE inflation index grew at 1.3% and 1.5%, significantly behind the regular PCE index of 1.9% and 2.2% (per latest Department of Commerce figures).
The Fed’s longer term monetary base* growth target was probably in the 6% to 8% range. We no longer have to guess where the Fed thinks the monetary base should be heading in the long run. Based on the new report with expectations of 5 ¾% growth, we should now readjust our monetary base growth target to 5 ¾%. It has been our experience within the last two years that broad money supply, also known as M2, has been very closely correlated with changes to the monetary base. Further the growth in the broad money supply has been correlated with nominal changes in GDP. Or, in other words, the Fed may expect the monetary base to grow about the same rate as the GDP.
Of course, there are many influences on the Fed’s short term policy decisions and actions. The Fed also must consider the schedule of new Treasury auctions, changes in the Treasury balances, banking problems, the actual level of the interbank Fed Funds rate, and many other factors when it decides what to do on any given trading day. Usually it makes minor (a few $billion ) adjustments to the amount of repos outstanding. So the Fed may veer away quite significantly from that 5 ¾% target in the short run, and may continue to do so while it perceives that some type of crisis or event is continuing.
For example, on Thursday the Fed added a net amount of $7.5 billion in repos, having to facilitate the settlement of $12.5 billion in net new Treasury bills. The call to the Federal cavalry went out Wednesday, but the Colonel Al didn’t show up with the repo reinforcements – making a dramatic entrance just in time Thursday (see Fort Apache).
We don’t know what base or starting point the Fed is using to implement its long term policy. Looking back over the past year, growth of the monetary base has been around 6 ¾% (as of 2/16/2005). If the Fed sticks to its word, we should expect further monetary tightness in the coming weeks – at least until the next crisis comes along.
“So it is written, so it shall be done.”
*The monetary base is mostly US Treasury bills and bonds the Fed purchases, plus temporary repos. A repo, short for repurchase agreement, is an agreement between the Fed and brokers from the primary group of 22 approved Treasury dealers. Usually one dealer sells the Fed a Treasury bill at a specified price with a commitment to buy the security back later for another specified price. The difference is based on the interbank interest rate, called Fed Funds rate. Most repos are overnight transactions, with the sale taking place one day and being reversed the next day. The Fed also makes occasional outright purchases of Treasury bills and bonds, which mostly occur during and after Treasury bond auctions. The monetary base is ‘high-powered’ money – sometimes called ‘super-money’ - which is pipelined directly back to Wall Street. It’s used by major brokers and beyond to Main Street as a base for leveraged credit expansion, i.e. buying more US Treasuries, and stocks, mortgages, etc..
posted Thursday February 17, 11 47 AM ET
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