Financial Liquidity & Monetary Policy

On balance US financial system liquidity has changed little since early
in the year. My broad measure of credit driven liquidity remains
flattish as further contraction of the commercial paper market and
shadow banking system are offset by rising personal and business
savings via money markets and CDs. The Fed has drawn authority
to increase its balance sheet by nearly $1 tril. more, but has not used
it. In fact, Fed bank credit has contracted since the 2008 holiday
season.

Banking system equity capital has increased by 9.5% yr/yr, as
TARP money and new offerings by larger banks have dwarfed
miniscule internal growth for the system. Liquidity is still tight
at the margin as C&I loans remain in the early stage of a cyclical
run-off. Total loan exposure remains flat, which is not atypical in
a major economic downturn.

On a global basis, the breadth of new manufacturing orders has
increased sharply in 2009, with the US and China leading the way.
There have been numerous reports that China is stocking basic
materials, including bunker crude. With some inventory speculation
underway, petro prices have jumped as have commodities, as traders
get on the recovery anticipation bandwagon. The CPI in the US,
excluding seasonal adjustment, has been rising this year so far. The
Fed has maintained a ZIRP policy and has fallen behind the seasonal
increase of inflation. Basic economic benchmarks for Fed policy are
giving readings well below what would normally trigger rate increases
as the economy has yet to move into an expansion phase. The
continuation of a ZIRP with commodities on the upswing has probably
contributed somewhat to a steepening yield curve and a weaker US
dollar.

The Fed would prefer not to jeopardize the now fabled "green shoots"
with tighter monetary policy, and probably does not now mind a
weaker $. However, persistence of fuel and commodities price rises
over the remainder of 2009 would put the Fed well behind the curve,
as inflation pressures would increase.

Ideally the Fed would like to wait for economic recovery to take hold.
With short rates near zero, the central bank would have ample leeway
to move rates toward more normal levels as the economy expands as
well as contract a Its very large balance sheet.

For the moment however, it is in a less comfortable position than it
was just a few months back, and it will be interesting to see how it
balances the prospects for the economy against higher materials
prices at its upcoming FOMC meeting, Jun. 23-24.