Sunday Morning Economics

Keep your eye on the money supply.

If you go back in time the Federal Reserve followed twin policies of:

1.  Purchasing Treasury securities from banks to increase reserves in the system.

2.  Selling Treasury securities to banks in order to drain reserves from the system.

This is easy to remember.  If you wish to loosen monetary policy you add reserves to the system.  If you desire to tighten monetary policy you drain reserves from the system.

As a consequence of either of these actions banks have to trade reserves with one another to meet their reserve requirements.  When the Fed manipulates the supply the interest rate that banks charge one another is impacted.  A policy of scarceness resulted in stable interest rates and low inflation for as long as I can remember.  

Along came the Financial Crisis of 2008-09 and the policy of scarceness was supplanted with a policy of abundance.  The Fed literally flooded the system with more reserves than ever before.  Moreover, the Fed manipulated the reserve system by paying banks to hold them.  Banks no longer had to engage in overnight trading amongst themselves to meet their reserve requirements and thus a market interest rate.  Banks could sit on their hands and wait to see whet the Fed would pay them to hold them.  (4.65% per annum) 

Result?

No more market interest rates.  Instead it is determined by the Fed.

Getting back to the first line in this post. During the first two years of the Covid pandemic it was a policy of abundance on steroids.  The money supply (M2) ballooned by more than 40%. Abundant fuel to allow inflation to rear it's ugly head.

In an effort to beat inflation into submission the Fed has engaged in a series of interest rate hikes and beginning in 2022 the M2 has shrunk faster than at any time since the Great Depression.  I may be old but I wasn't around that long ago so my frame of reference is the early 1980s.  That's long enough ago to suggest I've never seen anything like this.

M2 data comes out early next week and we'll learn weather or not the money supply has continued to shrink this year and whether additional increases in interest rates will impact the money supply further in 2023. 

We are living during interesting times.  It remains to be seen if raising interest rates is impacting the M2.  If the Fed reaches a point of cessation will the supply of money continue to shrink on its own?  Or will it reverse on its own?  This is uncharted territory.

Unlike the sound bites spouted by political partisans or what you might drink from the Face Book cesspool of lazy economic thought when the Fed influences monetary policy its impacts are not felt immediately.

As always, with economies the size of a aircraft carrier when you tweak the rudder it takes considerable time to turn the ship.  It's too soon to know for sure whether, or not, there will be a soft landing or if the economy tips into a recession.

Keep you eye on the money supply.  

And stay tuned.....