Did Fed Tightening Help Bring About The Current Market Downturn?

Posted 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 … read the rest