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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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6 Responses to A Current Read on Monetary Policy

  1. James Dailey says:

    I find your comments regarding the Fed and banks interesting but I am confused. The Fed can “encourage” banks to lend via lower rates and/or lower reserve requirements, but they cannot control risk preferences. In my mind the Fed can just re-enforce appetite for risk (throwing gas on the fire) or they can squirt a water gun on a raging inferno if risk appetite shifts. Your analysis ignores the fact that both the demand for credit and the supply of credit is largely driven by the risk preferences of borrowers and lenders. The Fed is just a price fixing entity that will encourage shortages or gluts.

    The Fed has been so aggressive in trying to manage expectations for a reason I believe. It seems obvious to me looking at the data that they have largely lost control of the money supply – they don’t target the supply of money anyway. They simply price fix interest rates. As Volcker argued, one can try to control the supply OR the cost of money but not both. The real explosion in bank and non-bank lending (fueled by mortgage finance, derivatives and the reach for yield among return starved pension funds) has little to do with the Fed in my opinion. The argument some would make is that the Fed is responsible for not being the adult and trying to take measures to target the supply of money rather than interest rates – hence address asset bubbles pre-emptively.

    The Fed is left impotent now to try and stoke risk appetite. Their tool is to cut rates and make mistaken “relative valuation” arguments like yours more common. Of course, the problem with relative valuation work is that long term success is driven by absolute value – not relative. One could argue that stocks look cheap relative to bonds but that bonds are ridiculously overvalued. So why would I want to invest in an asset that is expensive in absolute terms but cheap relative to an extremely overvalued asset? I just don’t understand that rational.

  2. Readers in the NYC area may be interested to note:
    Paul Volcker will be speaking at a Japan Society Corporate & Policy lunch on THURS., Oct. 4, 2007 at noon.
    Alan Blinder of Princeton, former Fed vice chairman, will preside.
    Reservations: visit and click on the lecture title, or click on top-menu item Global Affairs and then Upcoming Corporate & Policy Events.
    (Japan Society is at E. 47th St. betw. 1st & 2d Aves.)

  3. AllanF says:


    I think it’s the old greed and fear. The Fed hopes to appeal to people’s greed before fear has a chance to take hold. History has shown once fear takes hold, especially on a debt crunch, it is a tough thing to break free of.

    So, I don’t think they are necessarily impotent YET. Indeed the stock market is showing the greed trade is in full force. Through in a little inflation to make cash a negative carry, and bonds only flat, I think people will stay with the growth trade.


  4. James Dailey says:


    I don’t disagree with you. My work on risk appetite suggests that we are at an inflection point – but that a speculative blowoff could occur in an increasingly narrow market rally. Heck the Chinese , infra and ag sectors are already in spec blow off territory.

    As for a fear/credit crunch, I believe that historians will one day write with conviction that our era was terribly misguided to believe that we could manage away recessions and that reducing economic volatility was actually a treacherous decision. Recessions serve a critically important role in creating long term economic health and the longer this all goes on the worse we’ll all be for it when it finally ends.

    I long for the day of political courage and leadership that Reagan and Volcker showed in the 1981-1983 period. Our “leadership”, on both sides of the isle, appears to be pathetic by comparison.

  5. Glenn says:

    Thank you David…as always enjoy your insights. I was going to ask for clarification on your John Hussman comment, but I see Dr. Jeff Miller beat me to it…and your reply was perfect. Thanks again.

  6. What did the “leadership that Reagan and Volcker showed in the 1981-1983 period” consist of?

    Did their leadership consist of lowering the effective federal funds rate from 20% to under 10%, increasing M2 at close to 10% annually, increasing M3 at the same rate, or doubling the size of the federal deficit? Because those things all happened from 1981 to 1983.


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.

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