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.
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.
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.
