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Fed Can’t Print Its Way Out

A well-known stock market commentator this week said, “There’s been no growth in the money supply for two to three years.”

He also suggested that the recent increase in consumer credit is a positive economic development.

Well, here are the facts. At the end of November, the latest date for which data is currently available, the most common measure of the money supply, known as M2, had risen 11.4 percent since November 2005 and 16 percent since November 2004.

(Just in case you wanted to know: The M2 money stock includes currency, coins and traveler’s checks held by the public; balances in commercial bank checking accounts; balances at credit unions; savings accounts and certificates of deposit accounts less than $100,000; overnight repurchase agreements at commercial banks; and non-institutional money market accounts).

A broader measure of the money supply, the MZM money stock, has risen at an even faster rate over the past few years.

As of Nov. 30, MZM had risen 18.2 percent since Nov. 30, 2005 and 20.8 percent since Nov. 30, 2004.

(In detail, MZM includes all of the components of M2 mentioned before, plus institutional money market accounts and greater-than-one-day repurchase agreements).

So, as you can see, the money supply has clearly grown over the past few years.

My guess is that the well-respected economist who made the comments about the lack of growth in the money supply was referring to a different measure of money, known as the monetary base. That’s defined as currency in circulation plus funds held by commercial banks at their respective region’s federal reserve bank (“reserves”).

Although the monetary base also has risen over the past few years, it has grown at a much slower pace than the M2 or MZM money stock. As of Dec. 31, 2007, the monetary base had risen a modest 4.2 percent since December 2005 and only 8.5 percent since December 2004.

So, you’re probably thinking “Why all of the talk about the money supply?”

The answer is this: When the money supply increases, short-term interest rates tend to decline, and when the money supply decreases, short-term rates tend to rise.

In fact, the Federal Reserve adjusts the target rate for the Fed funds rate by affecting the level of the money supply, or more precisely, by affecting the monetary base.

When the Fed seeks to lower the target Fed funds rate — the rate at which commercial banks borrow (overnight) from one another — the Fed increases its purchases of U.S. Treasury securities in the open market.

(Those who follow the Fed may have noticed that the press releases issued by the Federal Reserve following meetings on interest rate policy always begins with statement, “The Federal Open Market Committee decided to… ”. That’s why it’s called the “open market” committee, because it buys securities on the open market.)

Likewise, when the Fed desires a higher Fed funds rate, it sells U.S. Treasury securities.

However, the Fed is not able to set the exact level of M2, MZM or other money supplies, because there are other factors that affect the money supply.

For example, the ongoing credit crunch and large sums of money that commercial banks have lent to financially-strapped businesses and to individuals over the past six months has caused commercial bank reserves to fall — even though the Federal Reserve has increased its purchases of Treasury securities.

As a result of the decline in bank reserves, the monetary base has grown at an anemic rate over the past few months. In fact, the monetary base rose only 1.5 percent during December 2007 from the same period a year ago.

In light of the ongoing credit crises, the Fed will likely need to significantly increase its purchases of Treasury securities in order to increase the monetary base. Many Wall Street economists have recently been encouraging the Fed to take this step in an effort to lower short-term interest rates.

(Note: When the Fed increases its purchases of Treasury securities, the prices of those securities rise as a result of their increased demand and the yields — interest rates — on those securities therefore fall.)

Well, here’s what I have to say about the recommendations of these “insightful” economists. Go ahead, persuade the Fed to increase the monetary base, because one outcome is certain if the Fed follows the desperate advice of these “experts.”

The result will be that the exchange value of the U.S. dollar will plummet and inflationary pressures will skyrocket. Gold prices, already breaking records, will continue to surge.

In regards to the esteemed economist’s comment regarding the supposedly positive increase in consumer credit, you should consider the following: When the economy is in an expansion mode, an increase in consumer credit is usually a positive development, because such a development indicates that consumers are confident in the future direction of the economy.

To be more specific, when consumers feel good about their employment prospects and their future earning power (that is, salaries and wages), they tend to take out more loans for automobiles, consumer electronic devices and home appliances. They also tend to use credit card debt more willingly for spending on clothing and other personal items, as well as dining out at their local restaurant.

As a result, aggregate consumer spending tends to rise during such periods, as does the total output of goods and services (GDP). That’s because consumer spending accounts for approximately 70 percent of U.S. GDP.

However, when consumers become more fearful of losing their jobs and their confidence in future economic conditions falls sharply — which is exactly what has been occurring over the past two months — an increase in consumer credit should be interpreted as a very negative development.

This is especially so when a large number of consumers begin using credit card debt to help pay their home mortgage loan, as they have also been doing over the past few months. But, don’t worry, there’s also a way to profit from this type of supposedly “positive” economic development.

How would what goes on in the US economy affect the rest of the world, one would ask? Because US Treasury Securities are the world’s most trusted and are purchased by almost every enterprise public or private. So when they are catch a cold, the world sneezes …

Copyright (c) 2008 Money News

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