THE ARGENTUS OUTLOOK Continued from page 1
So far, huge increases in base money, with its potential to pump up M2, haven’t accelerated M2 growth. To understand why not, we need to look at the relationship between base money and M2—as defined by the money multiplier, or M2 divided by base money. In normal times, the ratio has been steady in the 8-9 range. Recently, it’s slipped into the 3-4 range, keeping base money from expanding M2 for the time being at least. What’s going on? Rather than expanding lending, banks have built up their reserves—to a staggering $3.5 trillion, up from $800 million in 2007. Low interest rates and financial instability have driven people toward liquidity and safety, increasing money demand. A weak economy also helps keep inflation tame by subduing the demand that starts prices rising. So don’t interpret today’s low inflation as a strong Fed commitment to price stability. Quite the contrary, low inflation may have merely allowed the Fed to pursue easy-money policies that in other circumstances would be regarded as irresponsible. On methamFEDamines The Fed’s balance sheet provides one measure of recent policies’ recklessness. Before the financial crisis, the Fed had held about $900 billion in assets for years. After three rounds of QE, the Fed has nearly $4 trillion in assets, with most of the recent buildup focused on mortgage-backed securities (see chart below ). The Fed could relieve potential inflationary pressures by shrinking its bloated balance sheet—a quantitative easing in reverse, selling securities to take money out of the economy. The Fed wavered and waffled, hinted and hesitated, but in the end it decided to persist in adding to a dangerous, inflationary balance sheet bulge. In effect, the Fed has the economy hooked on easy money—methamFEDamines, if you like. As with any
addiction, the good effects come first—notably, the stock market’s 150 percent surge since March 2009. The bad effects come later—in this case, perhaps higher inflation and slow growth in the future. When trying to kick an addiction, the bad effects come first, the good ones later, usually after enduring the pain of withdrawal. Once the Fed ends the stimulus and interest rates begin to rise, firms could cut back on borrowing, spending and hiring. Homebuyers could grow cautious, deflating a revived housing market. The stock market’s bubble could burst, leading consumers to pull back. The Fed wants none of that; nor does it want to rebuff the enablers lurking just outside its offices. For Congress and the Treasury, low interest rates make it easier to borrow and spend. The federal housing agencies like cheap mortgages and Fed support in the market for mortgage-backed securities. The Fed can’t keep the economy hooked on easy money forever. Everyone knows this, including Janet Yellen. Yet, the Fed persists, driven by hope that administering the drug a little longer will make the economy stronger, and allow for an end to addiction with minimal withdrawal pains. Investors shouldn’t count on it. Bad monetary policy rarely turns out well. A final thought. The Treasury benefits from the Fed’s hyped-up wheeling and dealing. Every year, the Fed turns a profit from buying and selling securities. After covering its expenses, the Fed’s remits what’s left to the Treasury. Before the financial crisis, the total ran between $18.1 billion in 2004 and $34.6 billion in 2007. The transfer has gotten a lot bigger—$81.7 billion 2010, $75.4 billion in 2011, $88.4 billion 2012. The Treasury can expect another windfall when the books close on 2013.
A Bloated Balance Sheet: How Will the Fed Unwind It? $4,000
$1,000
on the verge of tapering its securities purchases and letting interest rates rise. In the end, the long-awaited policy shift never happened because the central bank worried the tepid recovery might falter without continuing stimulus. Your clients no doubt found Fed watching a frustrating enterprise this year. They’ll probably head into 2014 in a quandary about what to expect from the Fed. Dr. Cox portrays a central bank with no good options. It can continue current policies—but the inflation risk will only worsen. It can finally begin throttling back on its stimulus—but higher interest rates may squeeze a weak economy. Policy uncertainty has become a fact of life in our times. Your clients can’t just throw up their hands. To meet their financial goals, they have to make judgments about what the Fed will do— and what it will mean for the economy. In fact, these assessments should come before investment decisions. They will to
In sorting out macroeconomic prospects the help they can get. Even then, your clients will sometimes be wrong about the
Other
Agency Securities Maiden Lane II and III, AIG
direction of the economy or the timing and
Mortgage-Backed Securities
impact of policies. They should be ready to
Currency Swaps PDCF Maiden Lane (Bear Sterns) Discount Loans
revise their judgments as new information points to changes in the outlook and the appropriate investment strategy.
TAF
Investing can’t be put on autopilot—
Securities/Repos
not in these times.
$500 $0 2007
quite a while. By August, the Fed seemed
and policies, today’s investors need all
$3,000
$1,500
to higher inflation have been in place for
put their money.
$3,500
$2,000
Easy money policies that could lead
a large extent determine where investors
Billions
$2,500
What It Means for Your Clients
By Argentus Partners, LLC 2008
2009
2010
2011
2012
2013
Source: Federal Reserve
About Michael Cox
Richard Alm
W. Michael Cox is director of the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business. He is chief economic advisor to Argentus22Partners, LLC.
Richard Alm is writer in residence at the William J. O’Neil Center for Global Markets and Freedom at Southern Methodist University’s Cox School of Business