VTI - Federal Reserve Watch: Some Rough Times Ahead

2023-05-26 17:04:08 ET

Summary

• Concern has been raised about the year-over-year decline in the M2 money stock.
• This decline needs to be considered along with the decline in the velocity of circulation of the M2 money stock which has, so far, offset the decline, itself.
• The Federal Reserve may have to deal with more money "sloshing around" the banking system than it originally thought when it began to "tighten up."
• Otherwise, the Fed seems to be on target with reducing the size of its securities portfolio and seems to be managing its interest rate increases well.
• There is still a lot going on in the economy and in the financial markets that may lead to a lot of problems to be faced by the Fed in the near future.

Many analysts have been concerned with the decline in the M2 money stock.

Over the past year, from April 2022 to April 2023, the M2 money stock has declined by 4.6 percent.

This decline "forecasts" falling economic activity, it "forecasts" a forthcoming recession, and, as some of the analysts have argued, it "forecasts" a pretty severe one.

This decline is shown in the following chart.

My concern, as I have expressed in many of my recent posts, is that the increase in the M2 money stock that took place before the M2 money stock began to decline was related to the special conditions surrounding the spread of the Covid-19 pandemic, the recession that followed, and the economic mess that has resulted from all these factors. This is along with the massive amount of money the federal government put into the system to ease or relieve some of the pain felt by the country and the massive injections of reserves into the banking system by the Federal Reserve to keep the financial system liquid.

But, what did people do with these monies?

It looks as if the public didn't spend them.

Look at this next chart. This is a chart mapping the spending habits of the American population. In effect, the American population did not spend the money.

The velocity of circulation of the M2 money stock dropped precipitously and since then has only recovered slowly. People did not spend all the money being pumped into the economy, they held it or put it into assets.

Take a look at what happened to the velocity of circulation of the M2 money stock over the same period of time.

As the M2 money stock expanded, the velocity of the M2 money stock dropped dramatically.

The velocity of the M2 money stock only started to rise modestly as the M2 money stock began to decline.

That is, the use of the existing money stock only began to rise as the quantity of the money stock outstanding began to fall.

This is important.

Did the federal government and the Federal Reserve pump excessive amounts of money into the economy that was not really needed and was not really used?

And, if this is true, what does this mean for the future?

If the M2 money stock continues to decline, will the velocity of the M2 money stock continue to rise, offsetting the Fed's efforts to fight inflation and get the economy "back on track"?

I believe that this is a very important question.

The answer to this question will reflect very, very important outcomes for the economy.

If velocity increases to offset the decline in the M2 money stock, the economy...and inflation...could continue on at excessive levels.

This would mean that the Federal Reserve would have to stay restrictive just that much longer and take much more money out of the banking system than originally planned.

The economy would be feeling the pain of economic policy just that much longer and just that much more severe.

We must continue to watch this process very carefully.

Federal Reserve Quantitative Tightening

The Federal Reserve continued to reduce the size of its asset portfolio, but only by $3.7 billion.

Since the quantitative tightening started, including accounting for changes in security premiums and discounts, the whole portfolio has declined by $776.4 billion,.

As the following chart shows the Fed has been very persistent and very consistent in its reduction of securities held outright.

The Federal Reserve also continued to support the banking system by keeping the banks sufficiently liquid in order that they may smoothly function in the money markets.

Reserve balances with Federal Reserve Banks dropped modestly in the last banking week, falling by $29.2 billion.

These "excess reserves" continue to show how the Federal Reserve has maneuvered through the period of banking turmoil that came about following the failure of the Silicon Valley Bank, and others.

The period of bank failures can easily be seen on the right hand of the chart.

The Federal Reserve actions, in this area, helped to stabilize the money markets and support the Federal Reserve in raising its policy rate of interest and maintaining its efforts to fight the inflation in the economy.

Conclusion

The Federal Reserve continues to keep on with its policy of quantitative tightness with rising interest rates.

So far the Fed has weathered the "turmoil" very well.

However, I believe there will be some pretty rough times coming ahead.

One, as I described above, is the problem connected with all the money the Federal Reserve has pumped into the banking system.

In my view, the Fed may have to stay tight much longer than it expected in order to reduce its securities portfolio by as much as is needed.

As I have written elsewhere, the Federal Reserve contributed to building up an asset price bubble in the early stages of its fight to avoid a financial collapse.

Now, we are on the other side of the asset price bubble and the Fed needs to adjust for all of the excessive looseness it created at the earlier time.

Plus, there is the question of a recession in the future.

And, there is just the general disequilibrium in the whole economy.

There are a lot of issues the Fed must face in the next year or so. It is not going to be an easy ride.

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