Liquidity Cycle -- Looking Ahead #1

The liquidity cycle is currently the strongest it has been during the economic recovery which
began in 2009. Normally when financial liquidity in the economic system accelerates, the
real economy and business profits will follow in positive fashion. With a short time lag,
stronger economic demand brings along faster inflation.

Presently, my broadest measure of financial liquidity to include Federal Reserve Bank credit
is growing a rapid 11% yr/yr. Now, looking back over the past nearly 50 years, the 11%
growth number is right up there with past periods of accelerating liquidity growth. However,
with the Fed's balance sheet at a high base, the growth rate of liquidity is set to slow
markedly over the next year even if the present QE program is maintained.

Since there are questions about how rapidly Fed only liquidity may be absorbed into the
real economy, I suspect the velocity of the liquidity will continue to decline because
confidence in the economy by consumers, banks and businesses still remains well below
normal. Looking conservatively, it is reasonable to expect that business sales in the months ahead have the potential to move up from the 3 - 4% area yr/yr  to about 6.0 -6.5%. This development would lead to faster profits growth and ultimately to a pick up of inflation from the recent
1.5 - 2.0% level to 3.0 - 3.5%. If the banks turn more aggressive and dip into excess reserves,
output and inflation could be stronger. So far, however, the banks have been very passive.

Believe me, the Fed's current $85 bil. per month securities purchase program has increased
its balance sheet to levels that are above what the Fed, including likely Bernanke, is
comfortable with. In fact, the pace of QE is now running faster than the expansion of the
monetary base did over the long 1932 - 46 stretch. Policy is thus moving the Fed into
unchartered waters, even compared to the long pull from the economic bottom of 1932. Thus
the pushback from some Fed board members and economists.

Prior to the latest cat fight over fiscal policy and the debt ceiling in DC, the leading economic
indicators I follow were flashing stronger as was new order data from purchasing managers'
surveys. The battle in DC may have rattled confidence in the very near term, but the liquidity
cycle still points to moderately faster economic growth ahead.

The Fed would dearly like to rein in the growth of its balance sheet and it also dearly wants
to avoid a 1937 scenario when a sudden extended period of "cold turkey" flattening of the
monetary base led to debacles for the economy and the stock market (The latter went down
about 45%).  Hence the "taper caper" -- the idea of slowly weaning the economy and the
markets off the big QE push. The idea of curtailing the QE program likely will present no
substantive economic growth issue if, and this is the big "if", private sector credit demand
finally responds more vigorously. Since banking system data show that the banks have
basically taken 2013 as a long holiday at the loan window, there are no assurances going
forward.

I'll use the little framework above up until the time is at hand for the Fed to put its QE
taper plan into effect.

The secret to successful use of an economic outlook framework is to look for data and
info that tends to disconfirm the base view and not just collect items that confirm it.

I plan to put up a few more posts shortly on the topic with focus on the capital and
commodities markets as well as factors that can undercut the view such as real household
incomes and the magnitude of excess physical capacity in the global system (There's a fair
amount).