Did Fed Tightening Help Bring About The Current Market Downturn?

Posted by John Slater on June 6, 2012

Bill Clinton often gets credit for the insight that the economy would drive the 1992 election, leading him to victory over George Bush. Actually it’s his acerbic sidekick James Carville who deserves the credit for that famous one-liner “It’s the economy stupid”.

Without a doubt, the economy played a major role in President Obama’s victory in 2008 as well. Now we’re in another election year and there is universal agreement that the economy is likely to drive the outcome in 2012. While most commentators are focused on whether QE3 is in the cards, we have a different slant on the current downturn. We suspect that the Fed has, possibly inadvertently, played a major role in bringing about this contraction, just as it did in triggering the crash in 2008. We’re also concerned that election year political pressure, driven by the economic slowdown, will force the Fed into a response with serious long term inflationary implications.

I’m an unabashed monetarist. Over long cycles money supply growth or the lack of it drives both economic activity and price levels. I understand that this is a simplistic view, that the collapse of velocity has changed the meaning of money growth, that the increased investor appetite for liquidity has skewed the numbers, etc. Simplistic or not, changes in the rate of growth of the money supply often prove, after appropriate lags, to be a great predictor of the future course of the financial markets and, to a lesser extent, the economy. So what are they saying now with the election less than six months off?

Every week the St. Louis Fed publishes a twenty-four page pamphlet called U. S. Financial Data, which provides a great snapshot view of monetary trends. Preceding the fall 2008 financial crash, in spring 2008 the Fed had pumped significant liquidity in the system to neutralize the Bear Stearns fiasco. M2 grew at an annualized rate of 18.1% From January 28, 2008 to March 24, 2008.


By late August 2008, the Fed had pulled back sharply with M2 growth from June 2 to August 25 dropping to an annualized rate of 1.5%. A number of observers have speculated that the Fed’s tightening was a major precipitating factor that led to the banking crisis of September 2011 and the subsequent financial crisis of fall/winter 2008/ 2009.

We’ve witnessed an eerily similar pattern since late October 2011. From April 21, 2008 to August 25, 2008 the five-month annualized M2 growth rate dropped from 9.6 % to 1.5 % for a total drop of 8.1 percentage points. From October 24, 2011 to May 21, 2012, the five-month annualized M2 growth rate dropped from 13.7 % to 7.2% or roughly 6.5 percentage points. In each case the drop resulted from withdrawal of monetary stimulus. Regardless of the cause, we have clearly witnessed a period of monetary tightening starting in November, 2011.

Each incidence has been coincident with stock market selloffs, though for now the market selloff and the decline in money growth are both milder than 2008. The lowest three-month M2 growth rate for the current episode is 4.8% from February 27, 2012 to May 21, 2012, as compared with 1.5% for the lowest from the 2008 period. While this provides some encouragement with regard to the possible depth of the current contraction, it also raises concerns about the inflationary impact of Fed policies.

At the end of August 25, 2008, a period of extraordinary financial stress, including the failures of Bear Stearns and Fannie Mae, 12 month M2 growth was 5.6%. On May 21, 2012, following a far more benign financial environment, 12-month M2 growth stood at 9.6%.

9.6% money growth is hardly what one would be tempted to call tight money in a period of very low inflation and low economic growth. Yet the tightening that has occurred has been sufficient to precipitate a rather sharp market correction and renewed fear of a global recession or worse. Like a habituating addict, the economy appears to be demanding a far larger monetary fix to return to a path of growth.

To pull the U.S. economy out of the ditch this time may require powerful medicine indeed. We expressed our concern earlier in the year that the on-again, off-again nature of current Fed policy is inexorably leading us into a cycle of rapidly increasing inflation much like that witnessed in the 1970s. The current bout of deflation and analogies to Japan notwithstanding, we are more convinced than ever that the yo-yo nature of recent monetary policy is inexorably leading toward more inflation.

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