Was Fed Easing for Real? Show Me the Money:
Lawrence Kudlow
New York, Oct. 26 (Bloomberg) -- Has the Fed really eased? After two small
reductions in the official federal funds rate, and much Wall Street ballyhoo
about Federal Reserve easing, a close look at commodity price indicators, bond
market spreads and bank reserve measures suggests that the central bank may
not have eased at all. There is little evidence that Federal Reserve Chairman
Alan Greenspan and Company have added measurably to the supply of
high-powered dollar liquidity or reversed the growth- slowing trend of
deflation.
First the commodity signs. The gold price has been slipping of late, falling
back to $292 after briefly rising above $300. The CRB index continues to hover
just above the 200 level, unchanged from a month ago and 16 percent below its
year ago mark. The oil-heavy Goldman Sachs index is 30 percent under last
year's level. And the farm-heavy Dow Jones futures index has deflated 16
percent over the past 12 months.
Now, if the Fed were truly injecting a sizable volume of new cash into the
banking system, then sensitive commodity prices would rise. But it's not
happening. Instead, the two quarter- point drops in the funds rate from 5.50
percent to 5 percent seem to be merely a belated move to follow market rates
down. Perhaps the Fed has become slightly less restrictive. Weak commodity
price signals, however, imply that the Fed remains behind the liquidity
curve, not ahead of it.
Bank Reserves Down
This is confirmed by the recent data on bank reserves and Reserve bank credit.
If the Fed decides to increase the supply of high-powered dollars, then the
open market desk steps up its purchases of Treasury securities (usually bills,
but sometimes notes and bonds) from dealer banks and brokerage firms and pays
with newly created bank reserves. These reserve additions are duly reported in
the weekly banking statistics published every Thursday night by
the Fed.
However, since the Fed's Sept. 29 announcement to cut the funds rate, the
level of non-borrowed reserves has declined from $44.4 billion to $43.7
billion. What's more, the latest two-week settlement period level for non-
borrowed reserves is $1.1 billion below the average level for the month of
September and 3.1 percent below the same period a year ago.
The most encompassing statement of bank reserve changes is contained in the
Fed's weekly balance sheet, known as Reserve bank credit. For the week ended
Oct. 21, the $490.9 billion level of Fed credit (primarily consisting of net
purchases of Treasury securities and loans to member banks) is $5.5 billion
less than the $496.4 billion level recorded during the week ended Sept. 30,
when the first funds rate cut occurred.
On a yearly basis, Reserve bank credit continues to rise by roughly $35
billion, a rate of increase that has not changed much over the past two years.
Sending Dollars Abroad
Changes in Reserve bank credit are the principal source of the monetary base,
compiled each week by the Federal Reserve Bank of St. Louis. At first blush
the base's yearly growth rate of 7 percent seems high, sufficiently so to
prompt Fed monetarists William Poole and Jerry Jordan to call for a higher Fed
funds rate and tighter policy last summer. However, a recent article by
Washington economist and former Treasury official Bruce Bartlett shows that
reported monetary base growth is sending a false signal. That's because the
largest swing factor in the base, currency in circulation, is being rapidly
exported to foreign countries.
According to Fed estimates of these dollar exports, foreign holdings of
dollars as a share of currency in circulation have risen from 40 percent
during the 1980s to 55 percent by 1997. With the recent currency devaluation
crisis in Asia, Latin America, Russia and elsewhere, global dollarization has
undoubtedly increased markedly in the past year. For domestic monetary policy
run by the Fed, this means that the money supply circulating inside the U.S.
is much smaller, and therefore policy is much tighter, than the reported data
would support. For example, after adjusting for the greenback outflow to
foreign countries the revised growth rate of the base is only 3.2 percent,
instead of 7 percent monetary base growth over the past year.
Broader money aggregates such as M2 are relatively less affected, because
currency comprises a smaller share of their total. However, the M2 supply is
largely determined by shifts in the demand for money, depending on decisions
by individuals and businesses to spend and invest. The only money measure
directly under Fed control is the monetary base, whose primary source is the
bank reserve policy of the central bank.
Demand Up, Supply Down
In work pioneered many years ago by supply-siders Arthur Laffer and Victor
Canto, the best reading of monetary policy can be gained only by comparing
growth rates of the monetary base (money supplied by the Fed) and a broader
aggregate such as M2 (money demanded by the market). Adjusting for the effects
of world dollarization, recent trends show 3 percent base growth and 7 percent
M2 growth.
This means that money demanded far exceeds money supplied, a view confirmed by
the deflationary slump of gold and commodity prices. In other words, Fed
policy remains very tight. Put differently, both at home and abroad, available
dollar liquidity is excessively scarce. This helps to explain why bond market
''quality spreads'' have deteriorated so much. The difference between high-
risk ''junk'' bond rates and gilt-edged 10-year Treasury note rates
has doubled from roughly 300 basis points (3 percentage points) about 600
basis points during the past year.
Since the first Fed rate cut, this spread has widened, though it has narrowed
slightly since the second Fed rate cut. What's important here is that the
widening of this spread over the past year signals market worries about credit
quality and future profits. The market is telling us that the risk of
recession is substantial, and the liquidity squeeze and resulting credit
crunch is serious.
Remember, commercial banks provide only 30 percent of the credit to today's
economy. Much more important are mutual funds and pension funds which,
operating through capital markets (including stock offerings, corporate bonds
and various asset- based bonds for mortgage, auto and credit card finance),
provide over 50 percent of the nation's credit supply. If a severe liquidity
squeeze causes capital markets to become dysfunctional, where lenders are
totally risk averse, then the current economic slowdown (1 percent to 2
percent growth) could easily deteriorate into recession.
Bond Spread Widen
On a global scale, the shortage of dollar liquidity has led to a massive
widening of the spread between emerging market bond yields and the 10-year
Treasury note. From about 500 basis points a year ago, this spread has grown
to nearly 1200 basis points, though it has eased a bit during the past two
weeks. This yawning differential confirms the recessionary forces that are
dominant among developing economies.
Any way you look at it, the fact remains that U.S. Fed policy is much too
tight. Policy-makers should recognize that commodity and financial market
price indicators contain far more information about monetary ease or restraint
than the federal funds interest rate. Only price indicators accurately gauge
liquidity supply and demand. The price rule message: to avoid recession at
home and satisfy the thirst for dollars abroad, the Fed must pump out a
substantial increase in high-powered dollar liquidity.
The longer the monetary department waits, the longer people will postpone
spending and investing decisions until expectations are satisfied that prices
and interest rates have truly bottomed. This is why the Fed should promptly
undertake a big easing move that substantially raises monetary base growth to
about 10 percent, a move that would put some life back into commodity prices
and relieve the credit crunch. Probably this would imply a 3.50 percent
to 4.00 percent fed funds rate.
But the key point is not the funds rate. Rather, it is avoiding deflationary
recession at home and an even worse crisis overseas. Congress could have lent
a hand by cutting tax-rates across-the-board; this would have quickly revived
sagging animal spirits by promoting new risk-taking. Failing this, the only
policy card left is money. We need much more of it.
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