Friday, December 19, 2008

A glimmer of light: Fed policy is working

There is a slew of bad economic news out there, but finally a glimmer of light emerges. The light is dull – a 40-watt rather than 200-watt light bulb- but is nevertheless there: Fed policy is working.

What is Fed policy? Fed policy is massive:
  • Adding $1.4 trillion in liquidity to the domestic and global banking systems via loanable funds and currency swaps
  • Making unprecedented loans to the private sector, American International Group and Bear Stearns
  • Buying agency bonds directly
  • Creating demand in the commercial paper market with $315 billion net transactions
  • Using the Treasury to sterilize inflows
  • On the horizon: buying U.S. Treasuries directly, mortgage-backed securities (MBS), and perhaps other instruments not yet mentioned (CDS, corporate debt, etc.)
Some signs that Fed policy is working:

Corporate spreads are stabilizing if not falling

The chart illustrates corporate bond indices for investment grade and high yield corporate bonds since the beginning of the year. A sign of relief is emerging as corporate bonds spreads - borrowing costs for investment grade and high yield companies - stabilize, even fall.

Corporate bond rates are important - the higher are the costs to borrow, the lower will the borrowing be for new capital investment. See this post to for corporate bond spread indices (against Treasuries) on a longer horizon.

The money supply – all measures of – is growing faster on a weekly basis

And surging on an annual basis

The chart illustrates various measures of the U.S. money supply (the data and definitions are listed here). The growth rate of non-M1 components of M2 (Table 4) started to fall slightly at the end of October, but has since then picked up speed. The 4-week average M2 – a better look at the trend – is growing at a record 8%. Finally, M3 (at least most of M3) is slowing on an annual, but it is reverting back to its longer-term trend rather than falling off a cliff. The Fed is keeping the money supply afloat; this will offset some of the negative price pressures going forward.

Mortgage rates are falling

Who said that traditional monetary policy – cutting the target federal funds rate – was dead, because clearly it is not. In the wake of the Fed’s December 16th announcement, mortgage rates fell with force to 5.27% (as of 7am on December 19th from And with the Fed gearing up for its $500 billion MBS program, I expect that mortgage rates will fall further, potentially driving up buyer demand in the housing market.

It looks like the U.S. economy is just skirting a financial meltdown. Phew, now we have a recession to contend with.

Rebecca Wilder


  1. And the President is making his decision on the autos known in less than a half hour. Wasn't the mortgage rate fall kind of precipitous? We sure need the buyer demand as more and more houses come on the market from the unemployed.

  2. 1)On spreads: I think it's too early to tell and if the spreads are only stabilizing and not reversing quickly, we're still at historically distressed levels that will make the cost of borrowing too high for business, especially in light of the credit rating hits that virtually everyone is taking.

    2)On money supply: Everything I've seen lately says that velocity of money is still so bad as to more than counteract the money supply increase.

    3)On mortgage rates: Definitely good news, although obtaining credit is still at distressed levels, so I don't know if it will be able to bring enough buyers in. Especially for those buyers who are waiting on the leaked possibility of the Gov't intervening directly under some program, for example artificially lowering rates to 4.5%.

    I don't think we've narrowly missed anything, we're in the middle of a financial meltdown. The only question is if it will get worse before it gets better. In light of the devaluation of the dollar and the likelihood of a "beggar thy neighbor" multi-nation devaluation race, I'm still voting for worse.

  3. Oh! I just can't wait for when the bond-bubble pops...tick-toc-tick-toc.

  4. Rebecca says "Fed policy is working."

    Exactly for whom are the acts of the Federal Reserve working, Rebecca?

    Propping up Zombie Banks and their bankers amounts to an egregious act of theft against street-level, authentic Americans.

    Acting as the Director of Credit Allocation, the Fed Reserve members reward failure and punish success.

    The forthcoming Distortion Effects of this Collectivization and Communization of Credit shall prove to be painful for all authentic Americans not invited to this largesse party.

    Acting as a cheerleading apologist for a Money and Credit Cartel that has so mismanaged their affairs does not vaporize away truth.

  5. Smack MacDougal:

    Right on. That's the political-economy.

    Bank credit is climbing (8+)%.

    The is FED supplying an "elastic currency", i.e., it is practicing the fallacious "real bills doctrine".

    I.e., The FOMC makes accommodations as business activity waxes and wanes (Christmas, Thanksgiving, tax season, etc.)

    St. Louis Federal Reserve Bank: Bank credit is defined as total loans and investments at all commercial banks.

    “The FOMC often refers to the “credit proxy” — daily average total deposits at all member banks.”

    Bank credit proxy used to be an FOMC target: “The Federal open market committee’s strategy remained essentially unchanged for more than three years, from Sept 66, when the committee first began including a bank credit proviso clause in its directive until Dec 1969.”

  6. From the standpoint of monetary authorities, charged with the responsibility of regulating the money supply, none of the current definitions of money make sense.

    The definitions include numerous items over which the Fed has little or no control (e.g., M2), including many the Fed need not and should not control (currency).

    The definitions also assume there are numerous degrees of "moneyness", thus confusing liquidity with money (money is the “yardstick” by which the liquidity of all other assets is measured).

    The definitions also ignore the fact that some liquid assets (time deposits) have a direct, one-to-one, unvarying , relationship to the volume of demand deposits (DDs), while others affect only the velocity of DDs.

    The former requires direct regulation; the latter simply is important data for the Fed to use in regulating the money supply.

  7. BANK CREDIT PROXY: The credit school monetary management statistical guidelines are broadly based, that is the money stock is the “by-product” of credit policy, and that an appropriate credit policy will automatically achieve the proper volume of money.

    It relied on such statistical criteria as the volume and rate of change in commercial bank credit: total, required, excess, non-borrowed, and free or net borrowed reserves.

    For short-period guidance, free or net borrowed reserves were interpreted and provided, the best indicators of the degree of monetary ease or tightness prevailing in the economy.

    For the longer term, the volume and rate of growth of bank credit became more significant.

    If the definitions of money were broadened to include all deposit classifications, i.e., by including savings-investment accounts/deposits in the money supply concept, then the money supply concept becomes in large measure a credit supply concept.

    In fact, changes in total bank credit are almost exclusively reflected in changes in transactions deposits, plus time/savings deposits (all bank deposit liabilities).

    The connection can be explained as follows: Time/savings deposits, rather than being a source of loan funds, are the indirect consequence of prior bank credit creation.

    In our monetary and banking system time/savings deposits are derived exclusively from transactions deposits, either directly, or indirectly via the currency routes.

    With immaterial exceptions it may be said that as time/savings deposits grow, the primary money supply shrinks pari passu – unless offset by an expansion of bank credit.

    Transactions deposits, on the other had, are the almost exclusive result of the credit creating activities of the commercial banks.

    That there is a close connection between aggregate bank credit and the aggregate volume of bank deposits can be verified by comparing the net changes in bank credit to the net changes in total bank deposits for any given period.

    Increases in currency are always at the expense of transactions deposits, either directly, or indirectly through the liquidation of time/savings deposits.

    It cannot be said, as of time/savings deposits, that increases in the public’s holdings of currency reflect prior commercial bank credit creating.

    It is more appropriate to say that expansions of currency are accompanied by concurrent expansions of Reserve bank credit.

    Currency withdrawals from the banking system are offset by an approximately equal volume of open market purchases of Governments for the portfolios of the Reserve banks.

    A growth of currency will, therefore, assuming no change in monetary policy, result in an approximately equal increase in the total primary money supply if the securities being bought by the Reserve banks happen to be sold by bank customers, but no increase in the money supply if the sellers happen to be the commercial banks.

    An increase in time/savings deposits, on the other had, always results in an equal decrease in the primary money supply if transactions deposits are the source of funds.

    Since the distribution of these sales among the banks and their customers is unpredictable, all that can be said is that the growth of time/savings deposits under these circumstances, will cause a decrease in the money supply disproportionately greater than the increase in time/savings deposits.

    In contrast, using money school criteria (ignoring shifts between deposit classifications) it would be possible for the commercial banks literally to monetize the entire debt of the country without any apparent change in monetary policy.

  8. Hi Irrational Doomsday,

    You said, "On spreads: I think it's too early to tell and if the spreads are only stabilizing and not reversing quickly,.."

    Touche on this point! But the weekly data show the high yield tightening by 155 bps - definitely positive.

    As for this point, velocity of money is still so bad as to more than counteract the money supply increase. I am a little confused.

    I guess that you are referring to the multiplier, rather than the velocity - because the velocity is still rather constant (nominal Y/M). Yes, the multiplier is falling quickly, but the Fed is pumping up the base enough to grow the money supply.


  9. Apologies if I messed that up, I've been out of grad school for a few years.

    But I'm under the impression that not only has the multiplier essentially dropped to 1 now:

    But even increasing the currency isn't doing much to the supply side of


    Because the hoarding of money is dropping V as well.

  10. To clarify further, I don't know any direct data on velocity of money, other than the ballooning reserves which indicate to me that money isn't moving out the door.

  11. Irrational Doomsday Blog:

    Yes, you are exactly right. In short, the problem is beyond the FED's control.

    I.e., the member commercial banks (credit & money creators) are expanding, but the non-banks (financial intermediaries) are languishing.

    The growth in bank credit has not offset the decline in savings and investment.

    (1) never are the commercial banks intermediaries in the savings/investment process,

    (2)rather the commercial banks are the custodians of stagnant savings, i.e., savings are impounded within the commercial banking system.

    Debt reduction, (the fall in the demand for, and the fall in the supply of, loan-funds), or deleveraging (unwinding contract positions), or disintermediation (encountering a negative cash flow, or the shrinking in size, or financial redemptions, etc.), all in multifarious ways, either stall, or contract the transactions velocity of money.

    This translates into decreasing rates-of-change in monetary flows (money times it's rate of turnover). I.e, it retards the growth of nominal gdp.

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