much of the recent debate on whether the fed should decrease the target federal funds rate further and by how much is based, knowingly or unknowingly, on the belief that such a move will improve bank balance sheets. with the federal funds rate at 3.00% and two-year treasuries trading at half that -- 1.516% -- at the time of this writing, a case can be made that the fed has yet to turn accommodative.
it's important to remember the fed's primary responsibility is to the banking system and its primary macroeconomic duty is to maintain some semblance of price stability. it's "owned" by commercial banks, after all. if it lets inflationary expectations get out of hand, it risks both missions.
many were concerned about the global imbalances that built up during the low-rate era, such as the us capital surplus and the weaker dollar. real estate was alleged to be in a bubble, and commodity prices in general were moving higher, etc. should the fed act to perpetuate these imbalances?
the smashing of the "shadow banking system" of hedge funds, asset-backed commercial paper, auction rate preferred securities, notional financing in the swap market, structured vehicles and all of the other things that have given us those 10- and 11-digit writeoffs in the last six months are placing good old commercial banks back to the role they once occupied as lenders. as their role increases, the measured money supply will increase by the mechanism of fractional reserve lending. if member banks have to keep a 10% reserve against their assets, each additional dollar of free reserves can expand the money supply by a multiplier of 1/(1-0.9), or 10, each time it is re-lent.
the absolutely bizarre result will be we had loose money without a surge in the money supply leading to an obvious increase in inflation, and then and only then an increase in the money supply. when milton friedman famously and correctly said, "Inflation is always and everywhere a monetary phenomenon," he did not specify whether actual monetary debauchery and measured monetary debauchery had to occur simultaneously.
commercial and industrial loans as a percentage of GDP, which fell precipitously during the greenspan experiment in reckless central bank buffoonery, began rebounding at the end of 2004. the last datum is for the fourth quarter of 2007, but it shows how bank lending actually rebounded during the first round of bernanke rate cuts.
it will be quite interesting to see whether this trend continues in the first quarter of 2008; if it does, we should expect higher money supply growth for each dollar of free reserves in the banking system.
monetary velocity is the ratio of GDP to money supply - the velocity of M2, which includes currency, demand deposits, savings accounts, certificates of deposit and money market mutual funds, declined sharply during the last rate-cut extravaganza.
the last datum here is for the third quarter of 2007. given the flight to instruments included in M2 and the slowdown in the economy, we should expect velocity to decline significantly for the fourth quarter of 2007 and first quarter of 2008.
monetary policy acts with long and variable lags, which is the polite way of saying that we do not know what is going to happen nor when. eighteen months is a good lead term, so if we compare the year-over-year growth rates of M2 to those for the consumer and producer price indices, we should use a 30-month lag.
if credit moves back from the shadow banking system to the real banking system, we should see the expected link between money and inflation reappear and look much as it did in the 1960s and 1970s.
what will happen once the credit crunch ends, as it inevitably will? we will have a lot of excess money looking for a return within an inflationary environment. this suggests that when the whistle blows all-clear, treasuries will be sold with a vengeance and a 2003-like flight-to-risk will occur even if the fed starts to raise short-term rates.
should be an interesting summer and fall in the markets this year.