A Current Read on Monetary Policy

Yesterday over at RealMoney, I made the following post on monetary policy:


David Merkel
Monetary Policy at Present
9/25/2007 11:29 AM EDT

Though I don’t agree with all of his theories, John Hussman did an excellent job describing how little the recent Fed loosening has done for monetary policy. There still has not been a permanent injection of liquidity since May 3rd. The monetary base is flat. The real changes in monetary policy have come through additional leverage at the banks. That comes through explicit policy waivers, policy changes (e.g., permitted collateral at the discount window, removal of stigma), and the “wink, wink, naughty boy” returning to bank exams.

That reflects in the monetary aggregates. M2 and MZM both have moved up smartly since the beginning of the temporary loosening, as have total bank liabilities, which is a good proxy for M3. That said, because LIBOR is high relative to Fed funds, it is less good of a proxy, because banks are less willing to lend unsecured to each other in the Eurodollar markets.

Think of it this way, US Dollar LIBOR has only incorporated 16 basis points of the 50 basis point rate cut, measured from the equilibrium level that existed previous to the latest crisis in 2007. During the rate rise, they moved pretty much in lock-step.

So, things are a little better on the liquidity front in the short-run, but not much better. If the banks begin to become more conservative, just for survival reasons (i.e., more leverage is permitted, but they don’t want to use it), the small effects of regulatory easing will be erased.

Position: none, but while I wrote this, my youngest boy (10) came up to me, and asked me to explain what the stock market was like during 9/11, and during the Great Depression. It is very rewarding to be with my family during the day.

After this, Dr. Jeff Miller of A Dash of Insight pinged me asking me to clarify a little.  My response went like this:

You’re right, I need to be plainer about where I agree with him, and disagree with him, and I’ll probably put that into a post tonight at my blog.  Oddly, his models, from what I can gather, work off of some sort of cash flow yield for valuation, and even have a “don’t fight the Fed” component to them, in addition to momentum.  The reason this is weird, is that from those simple measures, he should be far more bullish, but he is not.  My suspicion is that he assumes that profit margins will mean revert, which they will, but maybe that will happen a lot more slowly than many anticipate.

As for his theory on the Fed, he is off.  The Fed has real impact on the economy through its effect on short term rates, admittedly with a lag, and they can’t fix inverted situations, no matter how low rates go (like Japan).  They affect bank leverage quite a bit, and though not cost-less, it has a real impact on the economy, with less of a lag, unless they go too far.

In essence, Hussman got the data right, and part of the interpretation, but missed increased leverage at the banks, which so long as it is sustainable, will stimulate economic activity.  He also missed that “Don’t fight the Fed” generally works.  I understand his valuation arguments, but he needs to get more sophisticated, and look at relative valuations of stocks to bonds.  Stocks are quite attractive on a relative basis, at least for now.

Monetary policy and its effects are complex, and non-nuanced explanations do a disservice to readers, particularly when the investment prescription is too simplistic.  At present, the Fed has done little to increase the money supply directly, but has encouraged the banks to lend more.  If the banks can tolerate that, then good.  If not, then watch out, because the banks are integral to our credit-based economy.

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