Monetary Watch August 2010, The Fed exits its exit strategy

The Austrian take on where we are on the monetary inflation front and what’s next…

Where We Are

The money supply aggregates based on the Austrian definition of the money supply (TMS) slipped in July, with broad TMS2, THE CONTRARIAN TAKE’s preferred money supply metric, down an annualized 2.6%.  However, the more important year over year growth rate on TMS2 was a robust 10.3% in July, down just slightly from June’s 10.6% rate, making this the 19th consecutive month that TMS2 has posted double digit year over year growth.  The last time TMS2 saw this kind of string was during the run-up to the now infamous housing boom-bust, a string that saw 36 consecutive months of double digit growth.  True, not housing bubble worthy, at least not yet, but still a lot of inflation.

As was the case in June, one would not know it by looking at M2.  This mainstream money supply aggregate, the one so closely watched by the deflation “hawks” at the FOMC, but in the opinion of the THE CONTRARIAN TAKE a grossly misleading measure of the money supply, is showing a year over year growth rate of a mere 2%.

To an Austrian, inflation is alive and well.  To the FOMC, mainstream economists and investors alike, deflation is lurking right around the corner.

A Look at TMS2 Internals

Before discussing the prospects for inflation going forward, a look at the TMS2 internals is instructive.

To begin, inflation springs from two basic sources:

The Federal Reserve, via the issuance of currency and covered money substitutes, the combined total popularly termed base money, the bulk of which springs directly from the Federal Reserve’s power to monetize assets by writing checks on itself.

Private banks, via the issuance of uncovered money substitutes, which springs from the ability of those banks to pyramid deposits on top of base money (read create money out of thin air), when making loans or purchasing assets.

With that as background, a look at the chart below quickly reveals who has done the heavy lifting when it comes to inflation; i.e., who’s responsible for that string of double digit growth rates.  Hands down, it’s been the Federal Reserve, as private banking institutions have been generally unwilling to pyramid money substitutes on top of that mountain of base money.

So, with the bulk of the heavy lifting currently in the hands of the Federal Reserve, it should come as no surprise that with the cessation of the Federal Reserve’s asset purchase programs in March, and resultant leveling off of Federal Reserve Credit, money supply growth as measured by TMS2, although still robust, has eased, down from a year over year growth rate of 16.5% in November 2009 to July’s 10.3%.  And to repeat, in the eyes of the FOMC, with their focus on M2, a money supply rate of growth wallowing at a mere 2%.

All that could be changing soon, as it looks like the deflation hawks at the FOMC are about to step up and put a charge into the monetary aggregates.

What’s Next

Let’s begin with the August 10th FOMC press release, bold type THE CONTRARIAN TAKE’s:

Information received since the Federal Open Market Committee met in June indicates that the pace of recovery in output and employment has slowed in recent months. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising; however, investment in nonresidential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract. Nonetheless, the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, although the pace of economic recovery is likely to be more modest in the near term than had been anticipated.

Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.

The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.

To help support the economic recovery in a context of price stability, the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.  The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.

The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to promote economic recovery and price stability.

First, the obvious.  While it is true that TMS2 has been decelerating, the fact is TMS2 is still running at double digit growth rates. Simply said, there is a lot of inflation around, supported by a still huge Federal Reserve balance sheet. Yet, citing little signs of inflation, likely supported by that 2% M2 growth rate, it is clear that the FOMC has no idea inflation is this robust.

Second, and as a consequence, the FOMC has decided to not only continue to maintain exceptionally low levels of the federal funds rate for an extended period, but to exit its exit strategy, as it will now keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities.

Third, fully aware of the banks unwillingness to extend credit (again read create money), the FOMC ends its press release by assuring the market that when it comes to money it is prepared to do the heavy lifting once more, not only by ending its exit strategy, but employing whatever other policy tools it deems useful to insure the economy gets all the inflation it needs.

What are those policy tools?

As St. Louis Federal Reserve President James Bullard, a supposed hawk and voting FOMC member, laid it out recently – Q.E. II, meaning more asset monetization, before as he says the U.S. slips into a Japanese style deflation.

A position Federal Reserve Chairman Bernanke supports?  You bet.

Perhaps some short-term weakness still in TMS2, but don’t count on it for too long.  A few more disappointing economic reports, perhaps two or three more ugly employment reports, or maybe another credit event, and THE CONTRARIAN TAKE is thinking another round of Federal Reserve engineered inflation is right around the corner.

This time likely starting  from an already robust rate.

Based on the monetary insights of the Austrian school of economics, THE CONTRARIAN TAKE offers up the latest monthly money supply metrics for the U.S., Eurozone and Japan currency blocks.

To see the entire monthly series offering – the latest money supply data for all three currency blocks, with full historical data and chart work, as well as supporting definitions, sources, notes and references – click here on Austrian Money Supply.

For a quick link to money supply definitions, sources, notes and references, click here on Austrian Money Supply Definitions, Sources, Notes and References.

For the logic behind the formulation of Austrian money supply, read Money Supply Metrics, the Austrian Take.