Seven More Fed Notes

Perhaps I should start with a small apology because my post yesterday did not even consider the forthcoming release of the FOMC minutes.  Not that I would have had anything great to say, but being asleep is being asleep. 😉

1) I’ve been banging the increasing inflation drum for a few years, and now I think inflation is getting some traction.  There was the CPI report today, of course, but I don’t put too much stock in monthly numbers — there is too much noise.  (I don’t think anyone wonders why I don’t spend a lot of time on quarterly, monthly or weekly data releases, but if anyone does wonder, it is because the signal to noise ratio is low.  The shorter the period, the lower it gets.)  I follow a melange of public and private bits of data, but try to look at it over longer periods of time — at least a year if possible.  A rise in inflation will make the FOMC’s life difficult.  I have been arguing for asset deflation and price inflation for some time now, and that is not a mix that I would enjoy trying to manage, if I were on the FOMC.

2) But there’s another reason why I have been arguing for price inflation.  It was about four years ago that I suggested on RealMoney that the cycle would end when China begins to experience a bout of price inflation.  Well, we are there now.  It was simple for China (and other nations) to ship us goods or provide services when the US Dollar was stronger, and inflation was low.  It is much harder with a weaker dollar, and rising price inflation.  The people of China need American goods, not more paper promises stuffed inside their central bank.

3) A few central banks aside from the Fed have loosened recently, but not many, and not much.  The US is walking alone here, and other nations are trying to cope.  Many other countries are willing to let their economies slow a bit, and perhaps let their currencies rise versus the US dollar in order to reduce inflation.  A few are still tightening.  The inflationary impacts of our monetary policy continue to radiate out, and will continue to, until the Fed starts its next tightening cycle.

4) The way I understand the FOMC’s behavior at present, is that they will drop rates hard for a time, and then remove policy accommodation dramatically once normal economic activity resumes.  My concern is that it may be more difficult removing policy accommodation than many suppose.  The TAF is holding down the TED spread at present, though the TED spread is still high.  What happens when it goes away?  Extending liquidity is always easier than removing it.  And, as it said in the 1/21/2008 portion of the FOMC minutes:

Some members also noted that were policy to become very stimulative it would be important for the Committee to be decisive in reversing the course of interest rates once the economy had strengthened and downside risks had abated.

The FOMC is not intending on letting low short rates remain for a long time.  That would make me queasy if I had a lot of money riding in the belly of the yield curve, say 4-7 years out.

5)  How would I characterize the FOMC minutes, then?  Weak economy, but not a shrinking economy.  Difficulties in the lending markets; credit spreads are high.  Inflation higher than we would like, but economic weakness, especially that affecting the financial system comes first.

6) From yesterday, my friend Dr. Jeff asked:

What was the Fed reply about M3?  I have continuing curiosity about this topic, as you know.  My economist friends tell me that it is not a useful measure.  It includes elements that are exchanges not increasing monetary supply and is also not subject to policy action.  MZM is interesting, but distorted by investors selling stocks and going to cash.  The latest macro textbooks stick to M2.

Meanwhile, many wingnuts (not you of course) see the dropping of the M3 reporting as some conspiratorial move.  They credit large government bureaucracies with much more conspiratorial power than could possibly be mustered!

By reading actual transcripts, you have vaulted into the top 1% of Fed analysts – if you were not there already 🙂

The nice fellow at the Fed who e-mailed me back confirmed that I should be looking at the H.8 report for an M3 proxy.

This is what I wrote at RealMoney two years ago:


David Merkel
Taking a Substitute for Vitamin M3
3/14/2006 3:26 PM EST

If you’re not into monetary policy, you can skip this. Within the month, the Federal Reserve will stop publishing M3. Now, I think M3 is quite useful as a gauge of how much banks are levering themselves up in terms of credit creation, versus the Fed expanding its monetary base. I have good news for those anticipating withdrawal symptoms when M3 goes away: The Federal Reserve’s H.8 report contains a series (line 16 on page 2 – NSA) for total assets of all of the banks in the US. The correlation between that and M3 is higher than 95%, and the relative percentage moves are very similar. And, from a theoretical standpoint, it measures the same thing, except that it is an asset measure, and that M3 incorporated repos and eurodollars, which I think are off the balance sheet for accounting purposes, but should be considered for economic purposes.

But it’s a good substitute… unless Rep. Ron Paul’s bill to require the calculation of M3 passes, this series will do.

Position: noneI since modified that to be total liabilities, and not total assets.  My use of M3 is a little different than most economists.  There is a continuum between money and credit, and M3 is more credit-like, while measures that don’t count in time deposits are money-like.  My view of M3 was versus other monetary measures, helping me to see how much the banking system was willing to borrow from depositors in order to extend credit.  As an aside, non-M2 M3 growth is highly correlated with stock price movement (according to ISI Group).

7) I give credit to the members of the FOMC who said (regarding the intermeeting 75 bp rate cut):

However, some concern was expressed that an immediate policy action could be misinterpreted as directed at recent declines in stock prices, rather than the broader economic outlook, and one member believed it preferable to delay policy action until the scheduled FOMC meeting on January 29-30.

This is just an opinion, but on policy grounds, I would have found it preferable for the FOMC to have cut 125 basis points on the 30th, rather than the two moves.  I don’t believe that the FOMC should react to short-term market conditions, and in general, they should avoid the appearance of it.  Monetary policy works with a long and variable lag.  One week would not have mattered; the FOMC needs to consider the way their actions appear, as well as what those actions are.