The Fed's Tight Monetary Policy

There was an interesting article by Lee Adler in The Wall Street Examiner over the weekend in reference to the discount rate cut by the Fed last Friday (see
Futures Fireworks and Moral Hazards for more about that surprise move) and more importantly on whether or not Bernanke is pursuing a tight monetary policy.

Lee makes the case that the Fed is much tighter than anyone thinks. Let's take a look at the key snips from Throwing a Bone To A Starving Dog.

The Fed had to do “something” to give the world the impression that they were actually “doing” something. What did they actually do? Not much. The Fed did not lower rates. It didn’t even increase the monetary base. It just put on a show designed to keep the public con going. All Friday’s move effectively did was to lower the premium for these emergency loans to problem children by 1/2%. And right now Countrywide is the Fed’s seriously delinquent teenager in big trouble with the law.

As of Wednesday of last week the total outstanding [discount window]was $294 million. Not billion, million! Compare this with the total size of the Fed’s asset base of over $800 billion, and you get some idea of how truly insignificant the Fed’s symbolic ploy was.

Not only does the Fed not buy bad securities, the Fed does not buy MBS securities. At least they haven’t yet. They hold no such securities in the System Open Market Account. In fact, as this accounting shows, they reduced the SOMA by over a billion in the week ended 8/15, and cut another $6 billion on Friday. In a move that I missed during the week, the Fed took the rare action of not rolling over about a billion of its maturing Treasury notes. They virtually always roll over 100% of the maturing paper they hold in the SOMA.

The action of allowing paper to expire unannounced is a stealthy way of cutting the monetary base without anyone noticing. So, while the Fed Funds rate had traded well below the Fed’s target of 5.25% throughout the week, by Friday’s Open Market Operations they had gotten the rate back to 5.35%.

Friday’s move was not a policy move. The Fed just cut the premium at Benny’s Pawn and Discount Drive Up Window for Problem Children — a mean, futile, and stupid gesture.

This is not a sign of a Fed that has eased policy.

So far in this crisis, the Fed has NOT injected one cent of liquidity into the system except for that two day bulge on Thursday and Friday August 9-10, which they completely removed by Monday and Tuesday 8/13-14. The Fed remains tight in terms of the SOMA, and making matters worse, foreign central banks are dumping Treasuries to raise cash for injection into their own system in order to try and fix the extreme dollar squeeze in European credit markets. Last week they reduced their custodial holdings at the Fed by a record $17 billion. They actually sold $22 billion of Treasuries, but apparently the Asian central banks are still propping the GSE market as they bought $5 billion in Agencies.

It looks to me like the Fed is frozen in place like a deer staring into the headlights of an 80 mile per hour downhill runaway tractor trailer, while the ECB is fighting its crisis the only way it can, by selling Treasuries and injecting the cash into their system.

The fact is that the Fed remains shockingly tight in terms of the monetary base, which they have maintained at ZERO growth for the past 8 months, and LESS THAN ZERO in the past week when the sheet was hitting the fan. Sure that can all change next week, but you wouldn’t know it from the actions they took on Friday.

At this point, the cut at the discount window looks like nothing more than throwing a bone to a starving dog.

This hasn’t been reported in the media but last week a $9 billion fund of hedge funds made a cash request of $500 million from the institutional money market fund where they hold their idle cash. For the first time ever, this fund of funds didn’t receive the cash immediately. As of Friday they had been waiting two days. They are still waiting, and there has been no word on how long it will take until they get their money. This is a fund that earlier took a $600 million hit on the Amaranth fiasco. And they are still waiting for the $165 million or so that they were supposed to receive from the liquidation.

This is just one fund folks. There are others in similar situations, perhaps hundreds, perhaps thousands of funds.

The run on the bank is only just beginning. Is the Fed’s Friday smoke and mirrors act going to change that?

I doubt it.

Thanks Lee. Well stated. A couple of points of clarification:

That $500 million is a single request from a single borrower. Lee promised not to disclose the name of the firm waiting for the cash. He does not know the name of the institution holding the cash. Nonetheless he has reason to believe the money isn't tied up in Never Never Land at Sentinel but rather at some institutional money market fund . If so, there are huge problems outside of Sentinel that will be surfacing soon.

Monetary Base

When Lee referred to the monetary base declining over the last 8 months he was referring to the System Open Market Account not the Monetary Base as widely understood and published by the St. Louis Fed. In a phone conversation with Lee on Saturday, he agreed that he needs to be more clear on the distinction so as to not confuse his readers. Anyway, the latter is still rising year over year, albeit slowly, as the following Non Seasonally Adjusted (NSA) Monetary Base chart shows.

Monetary Base NSA 1985 - present



(click on chart for a sharper image)

Monetary Base NSA 1918 - present



Monetary Base NSA - The Depression Years



The above chart should be enough to prove to anyone just how false Bernanke's claim that the Fed was not printing money after the stock market collapse in 1929 and that is what “caused” the depression. The “real cause” of the great depression was the artificial boom that preceded it. We have now exceeded that artificial boom by any and every rational measure. Bernanke is a poor study of history.

M Prime (M') Updates

Many have requested an update on my monetary component called M'. The rationale for tracking M' can be found in Money Supply and Recessions. The following charts are thanks to Bart at NowAndFutures.

By the way there were some massive backward revisions to sweeps data going all the way back to 2003. Even with those changes the charts have not changed all that much. The net effect of those revisions, however, was erasing a small dip in M' below zero. It is currently sitting at +1.1% year over year. The negative M' I reported in May was revised away. Such is the nature of backward revisions. The CPI adjusted M' is still negative (and very negative if one believes John Williams' Shadow Statistics).

I am not sure how the Fed can determine changes dating back that far, but Bart tells me that such occurrences happen all the time. They are also a lot of work as that data has to be re-entered.

M Prime 1968-01-01 thru 2007-08-15
(click on chart for a sharper image)



CPI Adjusted M Prime 1968-01-01 thru 2007-08-15
(click on chart for a sharper image)



Revisions or not, from the perspective of Monetary Base, M', and the Systems Open Market Account (SOMA) tracked by Lee Adler, there is simply little truth to the statements frequently heard about the Fed massively pumping money supply.

Yes credit has been soaring but the distinction between credit and money is important to understand even in the fiat regime we are in. Gary North concurs and has stated so in a recent post called Monetary Statistics.

Mish has come up with a new aggregate, which he calls M-prime. He symbolizes it as M'. Using Shostak’s article as a guide, he argues that M' is superior theoretically because it does not include any credit transactions, i.e., "sell this asset and get money." I agree with his assessment.

M-3 vastly overstates the rate of monetary inflation and therefore price inflation. The Federal Reserve System finally ceased reporting M-3 a year ago. It took them two decades to come to the realization that the statistic has always been useless. Bureaucrats learn slowly.

This is why I rely most heavily on the statistic published by the Federal Reserve Bank of St. Louis: the adjusted monetary base. This statistic reveals what the FED is doing to inflate, stabilize (ha!), or decrease the money supply. It reports on the FED’s holding of monetary reserves for the American banking system. You can access it here.

Clicking on the above link I see that Gary North likes watching SOMA as well.

There is one non-chart that is worth monitoring: SOMA (System Open Market Account). This is the New York Federal Reserve Bank's weekly posting of the total value of U.S. government debt in the Federal Reserve System's holdings. This serves as the major component of the monetary base, along with gold (fixed) and currency outside of the banks. When SOMA stays stable, the FED is pursuing a tight-money policy.

But while M3 is indeed useless for many things as Gary North suggested, it is not useless for all things. As a measure of exploding credit it shows just how out whack our current system is. Most of the problem stems from two things:

• Nixon closing the gold window
• Fractional Reserve lending

With the closing of the gold window, the Fed increasing lost control of credit. M3 has soared ever since. Credit (a money substitute) was simply borrowed into existence. The GSEs gave a loan to anyone who could breathe and the money (credit actually) that was given to the home builder at closing and deposited in his account was lent out over and over again. This happened because the Fed kept rates too low too long, Greenspan encouraged it, and fractional reserve lending allowed for it to easily happen.

A thorough discussion of the difference between money and credit can be found in a Sudden Demand For Cash.

While the Fed was not officially "printing money", they willingly and purposely encouraged credit to explode. And explode it did, probably far more than the Fed wanted. So looking only at M' or SOMA or base money is not the only means of stating whether or not the Fed's policy is tight or loose.

But while the Fed can encourage or discourage borrowing via interest rate policy, it cannot force banks to lend or consumers or businesses to borrow. The point of no return is when it becomes impossible to pay back what has been borrowed, and there is no funding available to service the debts. That is what happened in Japan. And that is just now starting to happen here.

Ka-Poom vs. Deflation

On Saturday someone forwarded me a link they found on Best of the Web at Dollar Collapse. The link was to a post by Eric Janszen called A Financial Market Crash is a Process, Not an Event. Eric is increasingly bearish and the person sending me a link wanted to know if Eric had changed his opinion from "Ka-Poom" to deflation.

A call to Eric revealed the following.

• He has been in cash, treasuries, CDs, and gold since January. That is certainly a deflationary play in my book.
• He is expecting is an asset crash.
• He still is not expecting monetary deflation (at least not sustained) giving far more power to the Fed than I do.

Eric offered to do another debate but people were disappointed that there were no fireworks last time. We are in basic agreement over too many things. Not much if anything has changed.

On the other hand, Lee Adler believes Bernanke will prove to be a genuine inflation fighter. I strongly disagree with that. In fact it can easily be proven that Lee's assessment is wrong. Bernanke has a stated goal of +2.0% inflation. In addition, that positive inflation refers to prices not assets. The housing bubble we are in comes from ignoring credit bubbles and other poor monetary practices by the Fed such as sweeps and fractional reserve lending. Besides prices cannot be accurately measured in the first place which will leave Bernanke forever chasing his tail just like he is now. And finally, a goal of positive inflation is a goal of government sponsored theft.

I am pretty sure Gary North thinks there's a snowball's chance in hell of Bernanke of proving he is an inflation fighter over the long haul as well.

But the difference between my opinion and that of Gary North's and Eric Janszen is that while all three of us think Bernanke will try very hard to inflate, of the three of us I am the only one who thinks he will fail at the mission. From where I sit, Bernanke is going to have his hands full keeping banks solvent, let alone hyperinflating anything.

But when Bernanke tries hard to inflate (and he will) ... that's when gold is likely to resume its rightful role as money and begin a powerful runup to new all time highs. Perhaps we get a deflation scare first (people over-leveraged in gold for the wrong reasons are forced out) but the long term beauty of gold is that Bernanke does not have to succeed, he merely has to try.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/