Monday, January 31, 2011

Economic Outlook (Part 2) -- Monetary Policy

Part 1 (overview) of this series, which is taken from a recent presentation I made at UCLA, can be found here

Federal reserve monetary policy hasn't been this easy/accommodative since the inflationary 1970s. Short-term real borrowing costs are negative, a policy that is designed to erode the demand for money, expand the money supply, and push inflation higher.

The Fed has exploded its balance sheet in order to accommodate an explosion of money demand. If the Fed hadn't done this then we probably would have suffered from a deep recession/deflation.

The velocity of M2 money is likely to rise as money demand falls and confidence returns, boosting nominal GDP. Velocity fell sharply a few years ago as confidence collapsed and money demand soared. Things are just beginning now to reverse.

The growth rate of most measures of the money supply has averaged about 6% per year for many years. There is no obvious sign yet that the Fed's quantitative easing has had any impact on the growth of the money supply. Taken in isolation, this would suggest that the Fed's provision of reserves has been just enough to satisfy the market's demand for reserves and to accommodate a modestly growing economy.

The dollar is very weak—about as weak as it has ever been—and this reflects very accommodative monetary policy and deep concerns about the future of the U.S. economy.

Low real yields from the Fed and a very steep yield curve all but guarantee a continued recovery. Every post-war recession has been preceded by high real yields (tight money) and a flat or inverted yield curve.

Thanks to QE2, the fear of deflation has again all but disappeared. Inflation expectations now are close to the average of what we have seen in normal times.

The rise in Treasury yields poses no immediate threat to the housing market. Mortgage rates are still very low from an historical perspective. The combination of very low borrowing costs, rising real incomes, and a 35% decline in the real, average cost of housing prices in recent years has left homes more affordable than at any time in more than a generation.


septizoniom said...

dreck. amazing you would be so irresopnsible publish market valuation calls based on sentiment.

Benjamin Cole said...

IMHO, a very solid wrap-up by Scott Grannis.

I see a sustained bull market ahead, in equities and property. Nothing appears overvalued, yet profits are rising sharply, and rents have stabilized.

Avoiding deflation will become the Fed's goal in the years ahead--meaning they will keep the spigots open. Deflation has proved a nagging problem in Japan, one not easily shaken.

With open borders for capital, labor, goods and services, the US economy needs a lot of money before it overheats.

The Mississippi is a rivulet compared to the amount of money the Fed needs to pump into the huge $14 trillion economy to keep it expanding.

(I recognize real growth comes from investment in plant and equipment, infrastructure, and real training, and population growth, and lower taxes. I am for all of those things. But immediately, we need the Fed to print a Niagara on money).

Bill said...


Do you think the turmoil in the Middle East will have much impact on the markets this year?

Scott Grannis said...

Re Middle East turmoil: I have no expertise in predicting how bad things might get there. But so far, the market is not displaying and great signs of concern. I'm operating under the assumption that whatever happens will be much less than catastrophic.

John said...

The market has just completed its best January since 1997. It has done so in the face of the following:

1) Little to no improvement in unemployment

2) Great pessimism over real estate valuations

3) Continuing macro fears such as Ireland, Spain, Portugal, etc.

4) Inflation in China and other emerging nation economies.

5) And lately Mddle East turmoil with all the usual contagion metaphors.

Markets never move in a straight line forever. There will be price corrections periodicly. But to me it appears that for the first time in over a decade equities COULD become the asset class of choice in the investment world. IF that happens, there are mountains of money potentially available for equity investment.