Fed Policy

(New York, 9/20/2006) I did a spot about Fed Policy on Neil Cavuto’s show on Fox News this evening. Here’s what I talked about.

Bottom Line–It is good that the Fed stopped raising interest rates before they could do real damage to growth. It is not the rates that kill the economy, it is their impact on bank lending and credit markets. The Fed increased rates far too much over the past 2 years, which has begun to dry up lending. Ironically, we are fortunate that there was a coup in Thailand yesterday. This will make central bankers wary of creating another 1997 blowup (Thailand was the first sign of the Asian financial crisis then). Rates are going to move lower now.With a strong economy and rising profits, lower rates mean big gains in the stock market.

Monetary Base
This is the basic measure of Fed policy. When the Fed buys a T-bill the monetary base increases by exactly that amount. About 90% is held in people’s pockets as currency. The remaining 10% is held by banks as reserves. That’s the raw material for bank loans.
Increasing the monetary base is like shoveling coal into a furnace. The monetary base growth rate is the best indicator of demand growth over a long period.

The Fed has only increased monetary base by 3.2% in the past year (about half the amount that it would take to support current 6-7% GDP growth. It’s 1.1% over past 7 months—too tight. (Bank Reserves, St. Louis Fed .)

Bank Reserves
When the Fed increases the monetary base the public takes what they want to hold as currency and the banks get what is left over as reserves. Over the past year people have increased currency holdings (they are frightened by our government’s hysterical security language) so bank reserves—the stuff loans are made of— have FALLEN 1.1% (11.5% since February). Falling bank reserves will eventually shrink lending and kill the economy. Not good. (Adjusted Reserves, St. Louis Fed.)

Business Loans
After rising dramatically since May 2004, loans have flattened out since May. More than half of GDP is small business. They get their working capital from banks. If they don’t get it growth dies. (Commercial and Industrial Loans, St. Louis Fed.)

JR