Liquidity Cycle & Monetary Policy

Good to Its word, the Fed zeroed out the growth of Fed bank credit and the monetary base about
two years ago. Since then and as is typical, the economy lost most of its growth momentum and
the stock market has been anemically positive. The end of all quantitative easing resulted in a
substantial but not fatal tightening of monetary policy. The lackluster US economy has been
funded by the private financial sector. Not only did the private finance not fold its tents, it
provided sufficient credit to fund a slow, deflation prone economy with excess liquidity to
support both rising bond and stock prices. However, as the economy slowed down, the growth
of private sector liquidity did as well, and now with signs that the economy and the inflation rate
have accelerated, the growth of excess liquidity has shrunk, and it has become far more diffcult
to fund the capital markets. The big casualties have been the bond and gold markets.

With a stronger economy and more inflation, the private financial sector will respond by providing
faster funding growth through the loan windows. For this to happen, the Fed will have to move
to tighten policy further gradually so as not to create a liquidity squeeze via taking action that
flattens out the yield curve. If there are larger fiscal stimulus plans that come on the board over
2017 - 2018, The Fed will have to accommodate them up to a point so as not to choke off the
economy and provided the inflation rate does not accelerate too rapidly. US policy will have to
watch carefully the developing supply / demand situation in the oil markets as well because
if oil supply becomes meaningfully restricted, a rising oil price will push up the inflation
rate and lead to a significant wealth transfer from net oil consumers to net producers.

But, perhaps it is wise not to get too far ahead of ourselves. For a more nearly normal liquidity
cycle to play out, the US has to show first that it can sustain a faster rate of economic progress
and that It is finally overcoming the squeeze on primary system liquidity that comes directly
from the Fed. Recent economic data finally reflects a positive beginning to the process.