For the past several years, the US Federal Reserve has engaged in a historic liquidity operation intended to support economic recovery. As shown on the following three charts, M0, M1 and M2 have all surged to all-time highs as a result of these stimulus programs.
Unfortunately, these programs have had little positive impact on an economy that continues to be restrained by excessive debt accumulated during the last several decades. While money supply has grown substantially since the recession in 2008, monetary velocity has declined precipitously during that time period.
Essentially, velocity measures how fast money changes hands, providing a gauge of economic activity. In basic terms, when velocity declines sharply even as supply is being introduced at an unprecedented rate, the implication is that the added liquidity is not engendering economic activity. This is precisely what “pushing on a string” looks like. Consequently, the M1 money multiplier, which essentially measures the economic impact of newly introduced liquidity, has remained below the 1.0 level since 2009. Following a gradual rebound during the past two years, the multiplier ratio has plunged during the first quarter of 2013, signaling renewed economic weakness.
Again, the Federal Reserve can attempt to spur economic activity by introducing monetary stimulus, but it cannot force banks to increase their loan and investment activity. The velocity and multiplier data trends clearly demonstrate that the newly introduced money supply is simply remaining idle in places like bank reserves. Federal Reserve Chairman Bernanke understands the dilemma, but he would prefer to deal with any problem except deflation, so he has committed to flooding the system with liquidity for the foreseeable future and worrying about the consequences later. In fact, he has even admitted that his intention is to inflate risky asset prices. Recall that when the second quantitative easing program was introduced in late 2010, Bernanke stated in no uncertain terms that one of the primary goals of the program was to inflate the stock market. The following quote is from an article written by Bernanke and published in the Washington Post in November 2010.
Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. … And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
There is no question that the measures taken by the Federal Reserve during the last three years have fueled appreciation in the stock market, so, from that perspective, the programs have been a success. However, it must be noted that equity gains fueled primarily by government stimulus can be erased as quickly as they are created. The recent liquidity operations have created massive imbalances that will continue to drive violent moves both higher and lower as the system attempts to return to a state of equilibrium.
Additionally, there is absolutely no evidence to support the assertion that higher stock prices meaningfully support economic expansion. Historically, a 1.0 percent increase in the S&P 500 index has been accompanied by GDP growth of approximately 0.04 percent during the same year, 0.04 percent growth during the next year, and it has a negative correlation during subsequent years. There is also the problem of addressing the massive imbalances created by several years of artificially low interest rates. Fund manager John Hussman monitors the future inflationary consequences of current Federal Reserve policy and the following chart and excerpt are from a recent weekly commentary.
The U.S. monetary base stands at a record 18 cents per dollar of nominal GDP. The last time the monetary base reached even 17 cents per dollar of nominal GDP was in the early 1940â€™s. The Fed did not reverse this with subsequent restraint. Instead, consumer prices nearly doubled by 1952. At present, a normalization of short-term interest rates to even 2% could not be achieved without cutting the Fedâ€™s balance sheet by more than half. Alternatively, the Fed could wait for nominal GDP to double and â€ścatch upâ€ť to the present level of base money, which would take about 14 years, assuming 5% nominal GDP growth.
Of course, 5% nominal growth would likely make it inappropriate to hold short-term interest rates below 2% for another 14 years. So either the Fed will reverse its present course, or we will experience unacceptable inflation, or we will experience persistently weak growth like Japan has experienced since 1999, when it decided to take Bernankeâ€™s advice to pursue quantitative easing. My guess is that we will experience unacceptable inflation, beginning in the back-half of this decade.
Because of the strong relationship between the size of the monetary base (per dollar of nominal GDP) and short-term interest rates, it appears likely that short-term interest rates will be suppressed by Fed policy for some time, until Fed policy normalizes or inflation accelerates. The Fed is now leveraged 55-to-1 against its own capital. With an estimated duration of about 8 years on 3 trillion dollars of bond holdings, every 100 basis point move in long-term interest rates can be expected to alter the value of the Fedâ€™s holdings by about 240 billion dollars â€“ roughly four times the amount of capital reported on the Fedâ€™s consolidated balance sheet.
Ultimately, the normalization of the Fedâ€™s balance sheet â€“ outside of weak economic conditions â€“ is likely to press long-term interest rates markedly higher. This would be particularly true in the event that inflation accelerates and forces that attempt to normalize, which we expect in the back-half of this decade. As a result, the next economic recovery will very likely be associated first with a significant steepening of the yield curve, and only later by an inversion as the Fed scrambles to tighten.
For better or for worse, the Federal Reserve remains locked into this course of action for the foreseeable future. Chairman Bernanke believes he has the tools and expertise required to prevent the imbalances caused by the current stimulus programs from engendering massive economic disruptions when they are purged from the system sometime during the next several years. Seeing as no central bank in history has been able to accomplish that feat, it is highly likely that he will be unable to do so as well. Further, research based on eight centuries of data has clearly demonstrated that it is impossible to solve an excessive debt problem with yet more debt. Until we stop applying superficial, temporary fixes and begin to address the root causes of our current predicament, our economy will remain structurally weak.