Financial System Liquidity

The Fed continues to make sure that narrow measures of monetary
liquidity grow. This remains essential to underwrite the early phase
of economic recovery. Since I think the Fed ought to maintain higher
levels of monetary liquidity in the system through time, I remain a
cheerleader here. The broader measure of credit-driven liquidity
(about $13.8 tril.) has yet to sustain growth from month-to-month
and is about 0.7% above year ago levels. This performance reflects
the continued roll-off of private sector credit demand and the
spectacular collapse of the shadow banking system and hence the
commercial paper market.

Flat funding for credit is not a major issue in the early stage of an
economic recovery, because businesses can fund operations via
internal cash flow. Moreover, in the current situation, mortgage
demand in the residential market is only beginning to show a little
improvement. However, as 2010 progresses, it will become
more important for the credit markets to loosen up to provide
more funding of a rising level of economic activity. This will not
be as easy a process as in most past cycles, since there are a
number of banks still posting higher loss reserves from loans
made over 2005 - 08, and this constrains both capital and
confidence.

When bank credit is damaged as badly as it has been, the chief
credit officer at banks has the CEO's ear and can hold the
loan officers at bay and under control. He rules the roost. But,
as an economy expands and inquiries rise from decent credits, the
commercial side of the bank gradually regains power and $ finally
flow. Smart CEOs keep the chief credit person in play as a
consigliere once the commercial guys swing into action.

There has been a sizable amount of excess liquidity in the system
relative to the needs of the real economy. With recovery and
with no discernible growth trend in system liquidity, excess
liquidity is receding and could disappear for a spell by late
winter, 2010. That would remove a substantial support factor
for the stock market and could leave it vulnerable to a price
correction, especially if investment portfolio cash levels are low
(they are). So this is something for stock investors to watch
for early next year.