Financial System Liquidity

As discussed in recent posts, the monetary base has been shrinking. The Fed has also
shrunk its balance sheet in recent months as well. Even so, financial system liquidity has
improved some since mid-year owing partly to an acceleration of basic money M-1 and
modestly faster time deposit growth within the banking system. Private sector credit
demand continues to shrink, so the banks have been using increased deposits to buy
shorter term securities. Annual growth of M-1 has been 6.6% yr / yr and the same for the
past six months on an annualized basis. The growth of M-1 is critical to provide offset to
a broad base of funding, which is up but 1.2% yr/yr. More banks have been expressing a
willingness to increase loan portfolios, but there have been few takers. Households in
the aggregate are operating on a cash and carry basis, and business has yet to expand its
inventory commitment by more than a small margin.

The Fed is actively exploring how to increase money within the system and is now
widely expected to disclose a plan either early next month or at its mid-Dec. policy
meeting. Since the trend of the monetary base forshadows that of M-1 money (cash and
checkables), the Fed is running low on time to fund continuing recovery in the face of
private sector credit contraction. There has been dissension and vigorous debate on
the Board about providing more liquidity because doing so could make policy
execution far more difficult when credit demand finally does turn up and accelerate.

The guesses about Fed intent range from occasional piecemeal asset purchases out to
a grand "nuclear" infusion of $2 tril., which would increase total system liquidity
an extraordinary 17.5%. Most guesses by observers put the size of a new round of
liquidity infusion within a range of $500 bil. - $1 tril. My advice to the Fed is to go
the piecemeal route. Start out with a sizable asset purchase of between $100 -200 bil.
and state clearly that the Fed stands ready to provide limited but substantial further
assistance if and as needed to sustain economic recovery.