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M1 Multiplier Indicates The Fed’s Gas Pedal Is Broken

 March 11, 2009 02:11 PM
 


The Federal Reserve has attempted to combat the recession with the traditional monetary remedy of increasing money supply. The Federal Reserve controls the monetary base through policy and either steps on the monetary gas or brake. The theory behind this remedy is that increasing the monetary base will lead to an increase in the money supply (M1 and M2). Once this new money is in the system consumers spend and businesses profit. This relationship can be seen in the following chart depicting the monetary base and industrial production.

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Since 1959 increasing monetary base has indeed increased industrial production. The most statistically significant time lag is 6 months, implying that 6 months from an increase in monetary base, industrial production begins to increase. The Federal Reserve began a massive increase of the monetary base in September 2008. If the prior relationship holds we would expect an uptick in industrial production when it is released on Monday March 16.

However, this past relationship assumes the only mechanism for transferring money into the system is the monetary base, but with the advent and subsequent geometric growth of securitization the sensitivity of the Fed's preferred gas pedal has diminished.

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One way to measure the sensitivity of the Fed's gas pedal is to use the multiplier concept. A multiplier is calculated simply by dividing either M1 or M2 by the monetary base. In this way, the impact of monetary policy can be measured. For example, a multiplier reading of 2.0 would indicate that for every dollar the Fed puts into the system two dollars are created. Therefore, the higher the number the more sensitive the gas pedal.

The following charts depict the monetary base vs the M1 multiplier (M1/monetary base) and M2 multiplier (M2/monetary base).

What's striking about these relationships is that the correlation is negative. The the larger the monetary base, the smaller the impact on money supply. The inverse relationship is most pronounced in the M1 multiplier which has a near perfect negative correlation at both the 6 and 12 month time lag. If the transfer mechanism (i.e. the Fed's gas pedal) was working properly one would expect that the multiplier would either increase or remain stable, but it would not decline.

The declining effectiveness of monetary policy has major implications as the Fed continues to implement both orthodox and unorthodox policies. The continuing weakness in industrial production suggests that the traditional monetary measures have not worked and the declining multiplier relationship suggests that they will not work. Perhaps as the Fed embarks on quantitative easing the economy will respond, but to date the gas pedal is not working.

Disclosure: I am long TLT.

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