As pressure mounts from Barack Obama and his cabinet to solve the economic crisis, Citibank announced that they will use $36b of TARP money to make loans which hopefully reduce excess reserves at the Federal Reserve and increase money supply (M1).
Recently the M1 multiplier has fallen below 1.00; a multiplier below 1 implies that for every dollar the Fed pumps into the monetary base, less than $1 is created in M1 money supply.
The hypothesis behind boosting the monetary base to combat economic weakness finds its roots in the monetarist school of thought, more specifically Milton Friedman and Anna Schwartz. In their book,
, Schwartz and Friedman pointed out that the Federal Reserve did not do enough to inflate money supply during the Great Depression. The economic theory has served central bankers well for almost 50 years.
Looking at the the Monetary Base vs. Industrial Production since 1959 we find a picture that an economist would love. Since it is generally accepted that monetary policy can take at least 6 months to filter into the system it is prudent to lag monetary base 6 months when comparing to industrial production. In doing so, we find that since 1959 the correlation between an increase in monetary base and a corresponding increase in industrial production is 0.96, with an R-squared of 0.92. Nice, tidy and easily understood - step the on gas and the car goes.
However, over the last year this relationship has been breaking down or more importantly it has reversed. As the Fed pressed the pedal on the monetary base, industrial production has declined.
To be the sure the reversal is not as statistically significant as the data from 1959 to 2008, but it is cause for concern. One possible reason the multiplier is declining and the increased liquidity is not working is the interest recently being paid on excess reserves. In an effort to gain better control over the Fed funds rate, the Federal Reserve began to pay the banks for holding money in reserve. For more on this see my post from October.
The hockey stick chart above illustrates that since September a premium has been placed on liquidity. The Fed fueled the rush to liquidity by providing a safe house for cash. It is difficult to blame the banks, they have no idea what their loans are worth and are certainly not in any mood to make yet another bad loan. Once the Fed provided an alternative investment by paying interest on excess reserves the cash poured into the vault. So while the debate rages about what the banks should do with the money, nothing will change until there is a suitable alternative to the ultra-safe, ultra-liquid Fed funds market. Until those reserves begin to leave the Fed's vault the money multiplier will continue to fall and the economic situation will continue to deteriorate. Perhaps today's decision by Citibank is the first step toward new investment. However, it is more likely that fear of political retribution was Citi's motivation rather than a preponderance of new investment opportunities. After all, didn't they just lose one of their planes?
Disclosures: I am long SKF.