James’s Musings

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Monetary Policy Is Working—A Little

by James G. Beldock on November 16, 2008

Earlier this week I post­ed some back­ground ma­te­ri­al re­call­ing how re­al in­ter­est rates were neg­a­tive in the mid ’00s, thus in­duc­ing wild/out-of-control bor­row­ing (all of which was look­ing for places to invest—think CDOs). I was plan­ning to use the­se data to back up my sense that the Fed’s re­cent rate cut was at best in­suf­fi­cient (I may still be right) and at worst dan­ger­ous (looks like I was wrong). The lat­est data1 (re­leased on Friday, a few days af­ter I post­ed) show that the Fed is pump­ing un­fath­omable amounts in­to the mon­e­tary base, and it’s just bare­ly keep­ing mon­e­tary sup­ply from falling off the ta­ble.

To get a sense for what the Fed has done re­cent­ly, take a look at the ut­ter­ly un­prece­dent­ed jump in the ad­just­ed mon­e­tary base2:

adjusted-monetary-base

Your eyes are not de­ceiv­ing you: the Fed has pumped an un­be­liev­able amount of mon­ey in­to the mon­e­tary base. Classic mon­e­tary pol­i­cy at work, right? Well, it’s cer­tain­ly an im­ple­ment out of the clas­sic mon­e­tary pol­i­cy tool­box, but this is an un­prece­dent­ed ac­tion:

unprecidentedbasechange

Now the crit­i­cal ques­tion: is it work­ing? Well, a lit­tle. In com­par­ison to the mon­e­tary ad­just­ments made af­ter 9/11 to off­set the eco­nom­ic shock, the cur­rent ad­just­ments are three to four times big­ger, but they’ve had a sub­stan­tial­ly small­er im­pact on the broad­er mon­ey sup­ply3:

thenvnow

Compare the two red ar­rows in the sec­ond fig­ure to the or­ange ar­rows in the fig­ure im­me­di­ate­ly above. The ab­solute ad­just­ment to the mon­e­tary base (red ar­rows) in 2001 was some­where be­tween a quar­ter and a third as big as the ut­ter­ly un­prece­dent­ed in­flux the Fed just let loose, but the re­sults (or­ange ar­rows) is bare­ly no­tice­able. What’s go­ing on? The sim­plest ex­pla­na­tion I’ve heard comes from Bob Brinker, who ex­plains that M2 has seen the im­pact of the past two months’ mas­sive evap­o­ra­tion of wealth, while the ab­solute cur­ren­cy (mon­e­tary) base hasn’t. To my eyes, we can there­fore vi­su­al­ize the “spread” be­tween BASE and M2 on the right-hand side above as that very evap­o­ra­tion it­self

Speaking of spreads, it looks like there’s an­oth­er in­di­ca­tor that the Fed’s poli­cies are work­ing a lit­tle. The TED spread4 has im­proved dra­mat­i­cal­ly:

ted

Recent TED Spread his­to­ry. 5

All of this points to­wards a sim­i­lar con­clu­sion to the one I hint­ed at in my post ear­lier this week: mon­e­tary pol­i­cy alone isn’t go­ing to solve this prob­lem. A so­lu­tion will re­quire some time and some fis­cal policy—both of which will have to wait for the end of the lame-duck pe­ri­od and thus for 2009.

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  1. the St. Louis Fed re­ports most of its ma­jor mon­ey sup­ply “ob­ser­va­tions” every week, on Fridays []
  2. the Fed se­ries is called “BASE” and you can find it, and the rest of the mea­sures (“se­ries”) I am re­fer­ring to in this post on FRED at http://research.stlouisfed.org/. The BASE data, for ex­am­ple, can be found at http://research.stlouisfed.org/fred2/series/BASE. []
  3. as mea­sured by a dif­fer­ent Fed se­ries, called M2, which is phys­i­cal cur­ren­cy (M0) plus de­mand de­posits such as check­ing (M1) plus all man­ner of time de­posits (sav­ings, CDs, etc.). For an ex­pla­na­tion of the var­i­ous mon­ey sup­ply mea­sures, see http://en.wikipedia.org/wiki/Money_supply. []
  4. dif­fer­ence be­tween LIBOR and the 91-day Treasury Bill, rough­ly in­di­cat­ing the price of the cred­it sup­ply []
  5. source: Bloomberg, http://www.bloomberg.com/apps/cbuilder?ticker1=.TEDSP%3AIND []
Bill A. November 16, 2008 at 9:04 pm

This is a really great analysis, beautifully presented. I have been wondering about this. Thanks!

James G. Beldock November 18, 2008 at 11:32 pm

Hey, Bill. Thanks for your feedback! Hope to see you around these parts soon again!

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