Monetary Policy -- Liquidity

According to the Fed, the Fed Funds rate is still at an accomodative level. Monetary liquidity trends paint a different picture. Liquidity has become increasingly restrictive. The economy has been growing faster than the broad money supply (yr/yr). Thus, the velocity of money is rising and, correspondingly, liquidity is shrinking, relatively speaking. As most know, short rates tend to rise with velocity. We do not have a full liquidity squeeze, because banks have their credit windows open. Monetary velocity is not rising fast enough yet to signal an economic downturn, but is consistent with development of a more pronounced slowdown. Timing is a tough issue, because the banks are friendly. Businesses are not stressed in meeting expanded working capital needs because cash flow is still on the rise and companies are tapping credit lines easily.

The Fed can let the economy coast this way for a while, but to avoid a serious crimping of growth or a downturn, It will have to begin providing fresh liquidity sooner or later. The Fed is interested in a long growth cycle because that assures a rising revenue take for the Gov. which must progress in reducing Its deficit. When the moment comes for the Fed to reverse course and ease up, follow through will have a substantial impact on the markets.

The liquidity deficit relative to the real economy began to show up over March / April, 2004. You will note that since then the stock and gold markets have made little headway, the 10 year Treas. has been rangebound, lower quality credit yields have moved up and even the US dollar, which been strong this year, is still a notch below levels of early spring, 2004. Only the Long Treasury has been able to hold a rally.

So long as the Fed allows liquidity to taper down, the capital and commodity markets are at elevated risk. Even the Treasury market is vulnerable, since players may turn bearish if they come to think that the process of slowing the economy to wring out unwanted inflation pressure may take longer than earlier anticipated.

The smart money knows that liquidity trend is every bit as important as the level and direction of the Fed Funds rate. In fact, the Fed may well signal an easing in policy first in the liquidity area, particularly if business credit demand begins to ease off. One place to watch is what the Fed is doing with its own portfolio (For this series, click here).

Finally, for an excellent e-chartroom briefing on the economy, click here.