At times they're lightly sleeping, in the quiet of their room …

The Federal Reserve has quietly disappeared from financial news headlines in recent months, after the flurry of (presumably unwanted) attention the financial crisis has heaped upon it throughout 2008 and 2009. An amendment to the planned new financial regulation monstrosity, mandating an audit of the Fed by the GAO, has been repeatedly watered down, resurrected, and watered down again. No-one can have been more surprised than Ron Paul that his idea to audit the Fed has suddenly found so many eager supporters in both the House and the Senate, but is is actually understandable given the fact that one of the enduring features of grave economic and stock market downturns is the hunt for scape-goats.


Most of Paul's colleagues probably simply want to score a few cheap political points, while some may be more interested in deflecting attention from their own culpability in fomenting the recently deceased housing bubble (we refer here to the many misguided GSE excusathons that were specifically a specialty of certain Democratic politicians).

Contrary to most of his colleagues, Paul is probably one of the very few politicians (if not the only one) that are seriously interested in a truly fundamental reform of the monetary system, including the abolition of state-directed fiat money.

In any event, we can probably rest reasonably assured that a significantly watered down version of Paul's original proposal will be adopted, which is to say, business will largely continue as usual. The most recent news items of note concerning the Fed were a 'talk is cheap' type of reminder that 'one of these days, the Fed's balance sheet will shrink again, just not yet' (In St. Augustine's words: 'Da mihi castitatem et continentiam, sed noli modo.' – 'Grant me chastity and celibacy, but just not yet'). See 'Federal Reserve ponders a plan for asset sales' in the NYT.

That this hasn't gone beyond the 'pondering stage' yet can be seen below:



The Federal Reserve's balance sheet (source: NY Fed). Shrinkage remains in the pondering stage – in the meantime it keeps growing – click chart for higher resolution.



The second news item of note was of course the re-opening of currency swap lines with European central banks and the BoJ in order to alleviate interbank funding pressures in the euro-dollar market – which in turn is a result of counter-party risk once again becoming an issue (see the chapter on euro area bank exposures to iffy sovereign debt in  my article 'Government Actions in Times of Emergency'). With some Congressmen spending some energy on harping about similar measures in the past, the Fed felt it had to issue a 'bail-out denial' – see 'Fed swap lines not a bailout -Tarullo' as reported by Reuters as well as a  'Fed primer on swap lines' that was published in the WSJ.

Otherwise, it has become quiet around the Fed, with the release of the April FOMC minutes providing the usual bureaucratese word salad to be dissected by our financial Kremlinologists, a.k.a. 'Fed watchers', whose job it is to discover small hints in the semantics of the Fed's statements that  may reveal the leanings of the planners with regards to interest rates. The recent pop-up of a token hawk (Thomas Hoenig), who admittedly seems to talk sense (pdf) notwithstanding, this combing through FOMC statements is largely a waste of time.

All one needs to do is to watch the following data series:



The effective Federal Funds rate over the past two odd years remains firmly stuck below the upper boundary of the 'target rate' (source St. Louis Fed) – click chart for higher resolution.



Detail of the above graph, showing the most recent 6-month period, via the NY Fed. The effective FF rate remains inside the shaded area that represents the current 'target range' of zero to 25 basis points – click chart for higher resolution.



The 3 month t-bill discount rate remains quiet at a tiny 15 basis points, 10 bips  below the upper end of the Fed's FF rate target. The Fed's rate policy tends to follow developments in this market-determined rate, although we would argue that there is a feedback effect between expectations about future FOMC interest rate policy and this rate – click chart for higher resolution.



As noted in a missive at, the t-bill rate tends to 'front-run' the Fed's rate policy, so all that heavy-duty parsing of FOMC statements isn't likely to be very productive. The market's reaction in terms of the t-bill discount rate  is far more informative. This rate is currently telling us that there isn't the slightest danger of the Fed hiking rates anytime soon.

Ever since the Fed replaced the money supply targeting that was a hallmark of the Volcker era (in the early 1980's, the weekly money supply data were awaited by stock and bond market traders with bated breath like no other data series) with rate targeting, the effective Fed funds rate tells us a bit about the likelihood of money supply growth via the creation of money from thin air, since the Fed supplies or drains funds to keep the rate 'on target', or nowadays 'at or below the upper boundary of the target range' by buying or selling securities from and to banks.

An effective rate below target indicates that credit demand is weak, and that therefore no reserve additions are necessary to keep the rate on target. Given a lower bound of zero, only the upper end of the target range is of importance in this context.

As can be seen when drilling into the details, the rate does indeed fluctuate during the day, generally between 3 to 40 basis points, so there is still something for the open market desk to do, but presumably not much. Information about open market operations and the SOMA (System Open  Market Account) can be found here, at the Fed's web site.



The effective FF rate, intra-day range. The average effective rate has remained firmly below the upper boundary of the target range, but there are occasional intra-day spikes, keeping the open market desk busy – click chart for higher resolution.



The major reason why interest  rates remain so tame is the fact that private sector credit demand has collapsed, with both household and business credit demand cratering. Note that a recent sharp spike in consumer loans reported by the banks has nothing to do with increasing credit demand, but is rather the result of a one time accounting change (namely the return of off-balance sheet  assets to bank balance sheets as per new FASB rules). In the chart below which depicts total bank credit, you have to discount the spike back to the zero line accordingly.

The business loan growth chart represents a more accurate depiction of the current situation.



Total bank credit, year-on-year percentage change. The spike in 2010 is the result of a one time accounting change. Bank credit growth remains solidly in negative territory – click chart for higher resolution.



Year-on-year percentage change in business loan growth – still negative, if slightly less so – click chart for higher resolution.



We can conclude that ever since the Fed's controversial quantitative easing program ended in late March (this program is what has kept the Fed's balance sheet growing in spite of the removal of the special financing facilities that were instituted during the 2008 crisis), money supply growth has likely slowed considerably – in spite of the Fed pretending that the cost of capital should be zero by retaining its extremely accommodative rate target. An excellent summary of the data can be found in the monthly 'monetary trends' (pdf) publication of the St. Louis Fed.


Money supply data confirm a slowdown in monetary inflation

A number of monetary data have recently received attention. For instance, the rate of growth of the broad money supply series M2 has recently declined to a historically very low year-on-year level.



The year-on-year percentage change in M2 has slowed to a crawl – click chart for higher resolution.



However, is M2 really a good measure of the money supply? Austrians argue that this is not the case. The main reason for this is that M2 contains components that Austrians do not consider to be 'money' but rather credit transactions – which when counted as part of the money supply, lead to double counting.

Money is the medium of exchange, thus only forms of money that are instantly redeemable for cash on demand should be included in the money supply. There are slightly different views among Austrians regarding the components that should be counted in the Austrian money supply measure TMS (which stands for 'true money supply'), which center largely on the eligibility of savings accounts. In this instance I side with Salerno and Rothbard (both pdf files) that savings deposits should be treated as part of the money supply, due to the fact that they are nowadays as a rule redeemable for cash on demand and thus economically indistinguishable from demand deposits.

There is apparently an obscure legal provision that would allow banks to make depositors wait for 30 days for their money, but one can imagine that banks would rather not make use of such a rule given that if they were to do that, bank runs would no doubt ensue immediately.  Nonetheless, Frank Shostak (pdf) excludes savings deposits from the money supply on those grounds (but has to include sweeps in his money AMS measure as a result, i.e. demand deposits that masquerade as 'money market deposit accounts' – MMDA's – in order to circumvent reserve requirements, which are more strict for demand deposits).

As mentioned previously, an excellent summary of all these theoretical approaches including a comparative table that shows which components the various money supply measures contain has been written up by Michael Pollaro in 'Money supply metrics, the Austrian take'.  Pollaro has come up with an excellent and elegant Solomonic solution – he refers to Shostak's AMS as 'narrow TMS 1' and the Rothbard/Salerno definition as 'broad TMS-2'.

For practical purposes, the one component of M2 that creates the biggest deviations in this measure from the Austrian measures of money supply are money market funds. Money market funds are investment vehicles, that invest in commercial paper. This is to say, the claim on the money in such funds is transferred to someone else (the borrowers issuing CP), which makes them a credit transaction. It seems obvious that counting them as part of the money supply leads to double-counting.

And yet, this is one component of M2 that frequently suffers large swings (note that there are some components in TMS that are not in M2, but these are comparatively small – see Pollaro's article for the details).

In any event, the two Austrian measures TMS-1 and TMS-2 both confirm that money supply growth has begun to slow down quite markedly, although they show that the slowdown is not as dramatic as indicated by M2 or the 'reconstructed broad money measure M3' published by John William's Shadowstats – this is largely due to the aforementioned exclusion of money market funds from the TMS measures.

Below you find several of the pertinent charts from Pollaro's chart archive (unfortunately this link broke with June 19, 2010).



The year-on-year change in TMS-1 and TMS-2 vs. M2. As can be seen, the TMS measures are trending down as well, but far less than M2. Nevertheless, they show how money supply inflation has begun to slow down since the phasing out of the quantitative easing program – click chart for higher resolution.



A long term chart of the components of TMS-2 Note the acceleration in monetary inflation since the beginning of the secular bear market period with the topping of the Nasdaq bubble in the year 2000. Such vast money supply inflation is economically very detrimental, but in keeping with Bernanke's philosophy that the Fed needs to 'spur aggregate demand' by money printing during recessions – click chart for higher resolution.



M3, as reconstructed by Shadowstats. M3 growth has turned negative, mostly due to a large decline in institutional money market funds – click chart for higher resolution.





Although the government has largely replaced private sector credit demand by increasing its spending into the blue yonder, current monetary trends clearly reflect a slowing in money supply inflation from the heady growth rates immediately following the outbreak of the 2008 credit crisis.

This means that the statistical economic recovery will become increasingly tenuous, as economic activities that have been artificially propped up by monetary pumping begin to lose support.

Since all economic activities that depend on such artificial stimulus actually hinder wealth creation by diverting real resources away from wealth generating sustainable economic activities, a slowdown in monetary inflation must be seen as a positive development for the economy's longer term outlook – even though the liquidation of malinvested capital will likely result in a short term bust.

Securities prices that have floated higher on the large amount of free liquidity in the economy that resulted as a combination of monetary pumping and slow economic growth are likely to come under pressure as well if this slowdown in inflation continues.

The latter is of course a big 'if'.  It is impossible to say for how long the lagged effect of the previous pumping will play out (the effect of money supply inflation on prices is not uniform, and tends to occur with a considerable and highly variable time lag), but a failure of private credit demand to revive will likely shorten this lag time relative to previous experiences.

However, it is safe to assume that the Fed stands ready to increase the pace of inflation again should securities prices continue to falter and economic data begin to disappoint. As  Marc Faber remarked regarding this topic: "if we go down by 10-20% on the S&P 500, our money printer Ben Bernanke will flood the market, weakening the dollar," [and thereby driving up stock prices].

This is certainly in keeping with Bernanke's views – since his biggest concern is how to 'avert deflation' – the very view that back in 2002 recommended him to the establishment as the most capable bureaucrat to replace Greenspan as the new Fed chairman. Given the fact that the Fed drives by using the rear-view mirror, its actions will be led by the markets, with its responses accordingly lagging. A good test of how long these leads and lags will be is likely coming up soon if money supply growth continues to slow down, as seems currently likely.



Post scriptum: Hayek on money, a few general remarks, and the monetary situation in the euro-area

As Friedrich Hayek remarked in a TV interview many years ago (starting at 2:50), 'I am absolutely convinced that no government is capable, politically or intellectually, of providing exactly the  amount of money that is needed for smooth economic development' […] 'I'm convinced we shall never have decent money again, before we take from government the monopoly of issuing money', etc.

Amen to that.

Hayek's proposal was to let private institutions issue competing monies, and let the free market decide on which money it prefers to use. Such a solution would likely produce far more risk-averse bankers than the  current crop of central bank and tax payer backstopped financial buccaneers.

This seems a good moment to remind supporters of a gold standard that a gold standard under government control, though somewhat preferable over a fiat money standard,  is still worthless, as it will sooner or later be abused – abundant historical evidence to this effect exists. It is not even important that the money we use is gold, the most important feature of a useful money is that it be a market-selected money (however, historically gold has of course emerged as the most useful money commodity).

Money was a creation of the market that was usurped by government, always with the same goal in mind: to be able spend more than could be spent based on the  tax take alone. Often the initial motive was the financing of wars, as wars are costly and tend to put a big strain on a nation's economy and finances (the production of goods used for the destruction of lives and property is not an economic boon, as many falsely assume).

Since inflating the supply of money and credit has consequences that go well beyond the mere price effects of inflation – namely the misdirection of economic resources into malinvestments, which creates unsustainable booms that perforce must lead to economic busts –  there is no benefit to society at large in pursuing an inflationary policy.

Even a seemingly enlightened and well-meaning central planning agency can not help but deliver results that are worse than the results the free market would produce. Note in this context Hayek's bemused appraisal of the differences between his and Milton Friedman's stance on monetary policy.

Even though Friedman correctly identified free market capitalism as the sole credible source of wealth creation, he fell short of applying this reasoning to the topic of money. So somehow even many economists that are otherwise supportive of the market economy seemingly fail to realize that money is an economic good that obeys the same economic laws as other economic goods.

Leaving its production to a central economic planning agency makes no sense (however, since inflation is akin to an 'invisible tax' it can easily be seen why governments would like to keep things as they are). Monetary trends in the euro-area have up until recently also reflected a slowdown in monetary inflation. In a recent article on the euro area bail-out package, Frank Shostak posted these interesting charts of the rate of change of Greek and euro-area money AMS (this is 'narrow TMS-1' as per Pollaro's categorization).

Note here that the unusually large decline in Greek TMS-1 likely partly reflects the flight of deposits from the Greek banking system in the wake of the debt crisis.



Recent TMS-1 data of Greece and the euro-area at large, via Frank Shostak's article on the bail-out – click chart for higher resolution.



It is to be expected that these trends will soon reverse, given that the ECB has now decided on its own version of quantitative easing, involving the purchase of government bonds of the 'PIIGS' nations (Portugal, Italy, Ireland, Greece, Spain).

I have previously speculated under the heading 'the printing press is waiting in the wings' that since the ECB promised to 'sterilize' these monetary injections, it would have to sell better assets (such as German bunds, for example) from its balance sheet. I suspected that the resulting deterioration in the asset quality of its balance sheet would motivate it to ultimately follow in the Fed's footsteps, where a roughly similar 'asset swap' plan was eventually succeeded by the outright monetization of treasury debt and GSE debt, replenishing the Fed's reservoir of 'higher quality' reserve assets.

As it has now turned out, the ECB follows a slightly different script when it drains bank reserves to offset the injections resulting from its buying of PIIGS bonds. As Reuters reports:


“The ECB said it will start offsetting the purchases from Tuesday by taking one-week deposits from banks. It will offer an interest rate of up to 1.0 percent on any funds banks deposit, well above the 0.25 percent it offers on daily deposits. The move is a bid to bolster its inflation fighting credentials having abandoned its long-held resistance to government debt buying.” […] “As part of the new sterilization plan the ECB said it will allow banks to use the weekly deposits as collateral in its lending operations, a move that effectively gives them the option to reborrow (sic) the money again. "With one hand you give and with the other you take, it's not possible (to sterilize).. the result is still that the liquidity is there." said ING analyst Carsten Brzeski. The ECB said it will also repeat the operation next week and analysts now expect it to become a permanent feature.”


In other words, this is not really an asset swap operation a la the Fed's TALF program. Furthermore, it appears from the comments by Carsten Brzeski that there is somewhat more 'give' than 'take' in these operations – in other words, the measures are likely to once again increase the pace of monetary inflation in the euro area. It is no wonder then that the price of gold priced in euro recently hit a new record high of EUR 1,000 /oz. (although it has now backed off a bit from this exalted level as the oversold euro has begun to rebound).

In short, it appears the printing press isn't merely 'waiting in the wings' in Europe.


Charts by: St. Louis Fed, NY Fed, Michael Pollaro,, Frank Shostak,


he ECB said it will start offsetting the purchases from Tuesday by taking one-week deposits from banks. It will offer an interest rate of up to 1.0 percent on any funds banks deposit, well above the 0.25 percent it offers on daily deposits. The move is a bid to bolster its inflation fighting credentials having abandoned its long-held resistance to government debt buying.” […] “As part of the new sterilization plan the ECB said it will allow banks to use the weekly deposits as collateral in its lending operations, a move that effectively gives them the option to reborrow (sic) the money again. "With one hand you give and with the other you take, it's not possible (to sterilize).. the result is still that the liquidity is there." said ING analyst Carsten Brzeski. The ECB said it will also repeat the operation next week and analysts now expect it to become a permanent feature.”


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