Wednesday, February 6, 2008

[Latest Global Dollar Liquidity measure: +11.4% annual growth rate; latest Endogenous Liquidity Index: -44.6%]

Surely the most intriguing element of the Fed's balance sheet is the sharp contraction in the stock of Treasury securities held by the central bank. This reliable proxy of the monetary base is down 1.7% from January 2007 — the first monthly contraction since ... January 2001! The only way to make sense of the incredible shrinking monetary base, in my view, is to consider the odd shape of the yield curve (ten-year note yield vs. fed funds rate target). A year and a half of inversion has taken its toll on high-powered money. When demand for credit weakens and demand for bank reserves follows suit, there are only two equilibrium points: (a) the Fed announces a new, lower target for the fed funds rate; (b) the Fed contracts the supply of bank reserves by selling bonds.

Clearly, alternative (b) was the path chosen by Bernanke and Co. until very recently. Believe it or not, there is an ongoing dollar ... scarcity! With the latest FOMC move, which took the fed funds rate all the way down to 3%, the yield curve has recovered its normal shape. One last issue remains to be mentioned: do trends in the monetary base matter at all? From the persective of the Global Liquidity Blog, the answer is clearly: yes — and a lot. Shrinking base money completely justifies the aggressive easing of monetary policy. And don't rule out additional steps!

No comments: