Distinguishing the Fed's securities purchases from monetary expansion

There has been a bit of confusion about what today's FOMC announcement means with respect to Quantitative Easing. The statement says that " the Committee decided to conclude its asset purchase program this month". It's important to point out that while this is the end of the Fed's bond purchases (for now), the US monetary expansion has ended this past summer. The outcome is visible in the the banking system's excess reserves, which flattened out around July.

That in turn resulted in the US monetary base leveling off at just below $4.1 trillion, as the so-called "money printing" effectively ended in July.

This begs the question: How is it that the excess reserves and the monetary base stopped growing this summer while the securities purchases and the balance sheet expansion continued through October? The answer has to do with some other balance sheet items that offset ("absorbed") reserve creation. The key item to consider here is the Fed's reverse repo position, which became more impactful as the securities purchases ebbed.

While the Fed's securities program is just ending now, the US monetary expansion was finished months ago. Therefore, other than its psychological effect, today's announcement should have a limited impact on the economy.

_________________________________________________________________________

SoberLook.com

Sign up for our daily newsletter called the Daily Shot. It's a quick graphical summary of topics covered here and on Twitter (see overview). Emails are distributed via Freelists.org and are NEVER sold or otherwise shared with anyone.

QE3: the act of doing the same thing and expecting different results

As we approach the first anniversary of the Fed's monetary expansion effort (QE3), it's worth comparing the success of the current program with that of 2010-11 (QE2). At this stage the two are roughly equivalent in growing bank reserves.

Note: The official start dates were a bit different but the announcements took place around the same time

In fact just in the past few weeks the QE3-induced reserve growth exceeded that of QE2, as the total bank reserves (commercial banks' deposits with the Federal Reserve banks) move above $2 trillion (and the US monetary base moves above $3.2 trillion).

The key to these programs' effectiveness is their impact on credit growth. Here is the comparison. One could presumably argue that QE2 resulted in stemming the credit contraction taking place in 2010. It's hard to make that argument for QE3.

Given this result, why would any central bank want to continue on its current path? Some would argue it is to keep longer term interest rates low. But the 30-year mortgage rate is now some 60+ basis points higher than it was when QE3 was announced. So if it's not credit growth or interest rates, what is the mechanism to transmit this "unconventional" monetary policy into the economy and job growth?

You hear economists talk about how the Fed should continue buying securities at the current pace because the US economic growth remains tepid. But isn't this simply doing the same thing (now for a year) and expecting different results?

SoberLook.com

From our sponsor:

Fed's action won't influence deposit growth

A quote from an elevator mechanic in NYC: "You need to push the 'up' button to make the elevator come up. But pushing the button many times is not going to make the elevator move any faster."



We continue to receive emails pointing to what some have called "a broken monetary transmission" in the US. On the surface the argument looks compelling. The Fed's securities purchase program is expanding the monetary base - the amount of dollars in the system. In theory some of those extra dollars should encourage the banking system to extend more credit than it normally would, ultimately growing the broad money supply (M2 for example). But that's not how things turned out.

Unit = $ Billion

The argument goes that the banking system is broken and is unable to grow credit - which is being manifested as tepid growth in the broad money stock. Is that what's really going on here?

A closer look reveals that the slow growth in M2 is driven primarily by the leveling off in the amount of deposits in the US banking system (in the chart below the monthly fluctuations reflect the payroll cycle). Note that the spike at the end of last year is the "income harvesting" prior to higher tax expectations (see post).

Deposits in the US banking system (NSA, source: FRB)

But is this leveling off in deposits that unusual? How does it compare to changes in total deposit balances across US banks over longer periods? It turns out that the growth of deposits in the United States has actually been fairly steady - roughly 6.8% per year over the long run. The chart below shows a fit to 40 years of weekly deposit data.

While deposit growth fluctuated over time, it has maintained a steady growth trajectory. Recessions, market booms, Fed's policy, reserve requirements, etc. have had a relatively minor impact on deposit expansion in the long run. And based on this fit, we are currently right about where we should be in terms of the overall deposit levels.

The assumption that the banking system can generate unlimited amounts of broad money simply because the banks have been injected with record levels of reserves is wrong. Banks' capacity to grow credit has always been limited, and it's no different this time. The "monetary transmission" is not broken - it is simply constrained.

The recent fluctuations are due to flows into stocks, mutual funds, short-term income funds (see post), etc. Deposits in the system will continue to grow at roughly 6.8% a year as they have done for the past 40 years, possibly longer.  Therefore the broad money supply - a great deal of which are deposits - will never keep up with recent unprecedented growth in the monetary base (which is up 18% YoY). The elevator "isn't going to move any faster".

SoberLook.com

From our sponsor:

Why has the US broad money supply flat-lined in 2013?

The US money indicators have been showing something odd in the last few months. While the monetary base (M0) has been rising sharply due to increasing bank reserves (the liability side of the Fed's balance sheet), the broader money supply has stalled.

Both M2 and MZM measures of money stock have been relatively flat this year.

Some attribute this to limited bank lending driving the so-called velocity of money lower, "trapping" liquidity from entering the broader economy. That would explain the growing monetary base and stagnant M2 and MZM.

But stalled credit growth can not be the explanation - simply because bank lending in the US continues to increase at a fairly constant pace since mid 2011.

Loans and leases for all commercial banks chartered in the US (source: FRB)

The answer has to do with cash balances, particularly in money market funds. The amount of cash in dollar money market funds has declined sharply since the beginning of the year. The retail accounts show a particularly large relative drop.

Source: ICI

In preparation for higher federal taxes, both individuals and institutions took capital gains, received special dividends, and pushed incomes into 2012 where possible (see discussion). And these accounts have been deploying this cash from the beginning of the year - with a big chunk of it apparently going to equities. That should explain part of the equities rally we've had this year.

In fact a closer look at the broad money supply trend shows that the growth has been fairly linear except for the late 2012 jump which has dissipated this year. That's why the broad money supply looks flat from the beginning of the year. Here is another example of "unintended consequences" of government policy and policy uncertainty.

Now that the excess liquidity has essentially been used up, what does it say about the stock market rally going forward?

SoberLook.com

From our sponsor:

What's driving the rally in crude oil?

US crude oil prices have been moving up for nearly two months now. There are a number of possible explanations for this strength in crude, including ongoing Mideast unrest, expectations of higher demand from China, and of course the QE-driven "risk-on" trade.

MarketWatch: - Those include improving economic data, rising Mideast tensions, changing U.S. oil market fundamentals — with greater oil-export capacity out of Cushing, Okla., and the closure of a New Jersey refinery — and an increasing number of speculative hedge-fund net “long” market positions, or bets that oil prices will rise, he said.

March-2013 WTI contract (source: barchart)

But two recent developments make this rally particularly unusual.

1. US crude oil market is very well supplied. Inventories are materially above their the 5-year range.

Source: EIA

2. While some economists are talking about improved GDP growth in the US, the data so far is showing something quite different.

Near-term growth expectations in the US remain modest, particularly given the expiry of the payroll tax cut. Normally, slow economic growth and record supplies should limit a rally in energy prices. But these are not normal times and two other economic factors have taken center stage.

1. US monetary base hit a record last week as the Fed's asset purchase program goes into full swing. This is contributing to the "risk-on" trade.

2. And the US dollar has weakened in response, creating a positive backdrop for commodities.

US Dollar Index (DXY) (source: MarketWatch)

Yes, Mideast tensions and expectations of higher demand from Asia certainly contribute to this rise in oil prices. But absent major international supply disruptions, it will be the US monetary expansion and dollar weakness that will push crude higher - in spite of relatively weak economic fundamentals and a well supplied marketplace.

SoberLook.com

From our sponsor:

Low money multiplier does not justify ultra easy monetary policy

An number of readers responded to the post (here) on growth in US monetary base with "so what?" After all the so-called "money multiplier" has been at historical lows - meaning that the Fed's monetary expansion has not made its way into the broader economy. The argument is that all this new liquidity is "trapped" in bank reserves, as lending remains tepid.

According to this traditional school of thought, you need sharp growth in the broader money supply to generate inflation - a major threat to the economy. But there is a problem with this argument.

Greenspan's Fed also believed that as long as the money multiplier was at historical lows, loose monetary policy is justified. And in 2002-2005 the money multiplier was indeed at historical lows. This is what the trend looked like to economists before the crisis.

Inflation of course was not a major issue at the time - at least not by historical standards. And the Fed continued with loose monetary policy, as fed funds target rate hit 1% during 2003-2004. The fed began to raise rates in the second half of the decade, but by that time it was too late. Rate increases ultimately served to burst the housing bubble in 2006.

What many economists failed to realize - and many continue to do so today - was that the risk of excessive liquidity is not necessarily the overall price inflation. With US wages stagnant, those looking for a 70s-style inflation will not find it. Instead liquidity manifests itself in asset bubbles, which is exactly what was happening in the housing market at the time when the money multiplier was at the lowest levels in recent history (chart above). Plus in a global economy, inflation (including wage inflation) was simply exported to emerging markets nations.

Economists and market participants however find ways of rationalizing asset bubbles - just as they did with the housing market in the US and China's double digit growth (among other bubbles) during the first half of last decade. That's why using the traditional money multiplier as a rationale for an ultra loose monetary policy is not prudent.

As an example of where this excess liquidity may be ending up today, consider the fact that the average US corporate junk bond yield ended up at an all-time low of 5.93 last week (chart below). Of course market participants have dozens of ways of rationalizing this trend - just as they did with other markets many times before.

Therefore before dismissing the expansion in the US monetary base as inconsequential, consider the fact that in spite of low money multiplier, excess liquidity will find ways to distort markets right under our noses. And you don't need to generate headline inflation in order for these distortions to damage the economy when the correction finally takes place.

SoberLook.com

From our sponsor:

The 2012 winner for the best performing currency against the US dollar

The table below shows the world's top performing currencies against the dollar. Poland, which was somewhat shielded from the Eurozone by its ties with the big neighbor to the east (considerable capital inflows from Russia and elsewhere in Europe) has been the best performer among the mainstream currencies. In fact Poland, together with other EU nations who stayed out of the euro area - such as Sweden, and the UK - have seen their currencies appreciate.

As of 12/21/12 (source: WSJ)

There is one currency however that has outperformed all of these by a long shot, but you won't find it on the list. The currency is called Bitcoin (ticker symbol BTC) and it more than tripled this year.

Dollars per one Bitcoin (source: http://bitcoincharts.com/)

It's not issued by a country, nor is it a precious metal or a rare-earth. Bitcoin is an electronic currency that can be exchanged for some goods and services, particularly online. The currency is not controlled by a central bank. Instead it is maintained by a global registrar and managed via a private network of participants who get paid to "rent" their computing power to the network. The "rented" machines are used to maintain the integrity of Bitcoin transactions and act as a virtual decentralized registrar.

The network "node" providers (called miners) of course receive their payment in Bitcoin, with the overall currency amount growing gradually over time (current value of Bitcoins in circulation is about USD 140mm). The gradual growth in the "monetary base" is designed to prevent inflation. This is done via a complex algorithm that requires rapidly increasing computing power by the network providers to get paid the same amount. The number of Bitcoins paid to participants is halved periodically. At some point in the future the amount of Bitcoin will become fixed, with network providers relying fully on transaction fees rather than newly "minted" Bitcoins.

For more background on Bitcoins see this story from Wired Magazine (Wikipedia does a terrible job describing this process). It is a brilliant scheme to create a global currency that is separate from governments and central banks. The network however has had its share of growing pains due to hacker activities (specifically on a major Bitcoin currency exchange - not the network itself) and regulators. But it has survived.

The whole premise of this type of private network is to create anonymity online (see TOR Project). That means it is impossible to trace an online transaction. And therein lies the flaw of the Bitcoin concept: transaction anonymity attracts illicit activity. As an example, a website called Silk Road (you won't find it on the internet, since it lives on this private network) sells all sorts of things (paid only in Bitcoin), including illegal drugs. The site is estimated to have made some $22mm in the first half of 2012 but has received all sorts of scrutiny from law enforcement (for more on the site and the market, see the research paper from Carnegie Mellon).

So why has the currency tripled this year? A number of rumors have been circulating in the online forums trying to explain the rally. Unfortunately one explanation that stands out is the increased demand for illicit drugs online. Quite sad actually. Another explanation is the fact that the number of newly minted Bitcoins has been halved again in November, reducing the available supply.

Nevertheless Bitcoin is the 2012 winner for the best performing currency against the dollar.

SoberLook.com

From our sponsor:

Fed lowers mortgage rates without "printing money"

The Fed remains in a holding pattern. Just as comparison, take a look at the pace of MBS purchases during QE1 in 2009 versus the current pace of expansion.

$bn, source: St Louis Fed

More importantly, bank reserves are basically holding flat...

Reserve balances with Federal Reserve Banks (source FRB)

... and so is the overall monetary base (effectively no new base money has been created since the start of the QE3 program).

$bn, source: St Louis Fed

Just the "threat" of open-ended MBS purchases by the Fed has created demand for agency MBS (see discussion), pushing MBS yields to new lows. That in return has sent mortgage rates to record lows as well.

Source: Bankrate

In fact today even as the 30y fixed rate hovers above absolute lows, the 15y fixed and the 30y jumbo both hit records.

Source: MortgageNewsDaily.com

If lowering mortgage rates was what the Fed intended to accomplish with the latest monetary expansion, the central bank has succeeded. And so far they have done it without a significant change in bank reserves. Whether this will translate into improved economic activity and job growth remains to be seen (see discussion).

SoberLook.com

From our sponsor:

Fed's actions so far have not impacted the monetary base

So far the Fed's securities purchases have not had a material impact on bank reserve balances. As discussed earlier (see post) reserve balances will be the key indicator to watch in order to assess the level of monetary expansion.

Source FRB

In fact the St. Louis Fed's measure of the US monetary base has not budged. We are yet to see the rate of expansion we had witnessed during QE2 (left side of the chart below).

SoberLook.com

Gold lagging previous QE cycles but DB remains bullish

Deutsche Bank maintains its bullish stance on gold, in spite of missing their aggressive projection a few weeks ago (see discussion). Gold has underperformed the previous post-QE price moves, as shown in the chart below.

Source: DB

Part of the difference in this monetary expansion cycle from the previous ones is that the new program is having a fairly slow start in terms of its impact on base money. As shown in the chart above, Operation Twist for example had little effect on gold prices because it didn't involve increasing the monetary base (what some refer to as "money printing"). For every dollar in securities bought, there was roughly the same amount of securities sold, keeping base money from rising. Bank reserves, which is the primary mechanism for impacting base money, actually declined over the period since the Twist program was started (chart below). And the recent asset purchase initiative (QE3) has barely moved the reserve balances so far.

Source: FRB

Once the latest program begins to ramp up and bank reserves start growing again, real interest rates should move deeper into negative territory (see discussion) and the dollar should weaken (see discussion). That is likely to create a fairly bullish environment for gold. According to DB, the US fiscal uncertainty and potential risks of another debt downgrade will also support that market.

DB: - ... during the remainder of this year we expect the US fiscal cliff and further efforts by the Fed to extend QE will not only push long term real interest rates deeper into negative territory, but, also resume US dollar weakness. Moreover any speculation of an additional downgrade in US Treasury debt would be supportive to gold prices, in our view.

SoberLook.com

Swiss base money spikes as the SNB defends the peg

The Swiss National Bank (SNB) continues to "print" Swiss francs (CHF) in response to the flow of capital out of the Eurozone. As Eurozone residents exchange euros for CHF, the SNB buys these euros and sells (the newly "printed") francs to maintain the 1.2 CHF to EUR peg. As a result Switzerland's monetary base has spiked to record (CHF 274bn).

Swiss base money (CHF MM)

But Switzerland can afford to explode its monetary base for now because the broad money supply (M3) has been growing at 7.4% YoY (within the range of the last 4 years) and inflation has been negative. In fact this the situation looks deflationary given that core inflation is at record lows

GS: - "... despite moderate economic growth, the deflation risk for Switzerland is non-negligible. With the starting point of inflation already so low, a deterioration in the external environment could easily push the Swiss economy into recession, putting further downward pressure on prices.

Switzerland CPI (white) and core inflation (green)

That's why the SNB will vigorously defend the 1.2 peg for the foreseeable future and base money will continue to grow. In fact given the Swiss franc's appreciation in the past few years (up 36% since 2008), some are saying CHF is significantly overvalued and the peg should be greater than 1.2.

CHF per 1 euro (Swiss franc has strengthened by 36% since 2008)

Bloomberg: - The Swiss currency remains 36 percent overvalued against the euro, based on purchasing power parity as calculated by the Organization for Economic Cooperation and Development. That compares with 24 percent for Denmark’s krone.

SoberLook.com

The TARGET2 imbalances reference guide

For some reason the subject of Eurozone's TARGET2 imbalances continues to be of great interest to many. We keep getting numerous e-mails requesting more information on the topic. The paper included below can serve as a reference on TARGET2 imbalances and hopefully will answer a number of readers' questions.

The key to understanding this issue is to look at this "truck purchase" example in the paper and follow how it impacts the national central bank balance sheets.

In this example the Greek central bank has to reduce "base money" while Bundesbank increases "base money" - effectively "transferring" cash from the Greek banking system to the German banking system (to pay for the truck). Simultaneously Bundesbank now has a future claim on the ECB while the ECB has a claim on the Greek central bank (effectively to reverse the "cash transfer" in the future). With significant periphery trade deficits, these claims have grown quite large.

Impact on central bank balance sheets with a cross-border transaction

The concern around TARGET2 imbalances is that central banks owe a great deal of money to each other via the ECB and should a nation drop out of the Eurozone, these liabilities may not be met. The ECB may then have to take a large loss. A mechanism for a nation's exit from the euro area was never developed.

But one question that few have asked on this topic is what is the net impact on base money in Germany vs. the periphery. Clearly this base money imbalance (table above) will also create uneven money stock and significant liquidity tightening in the periphery vs. Germany.

For example if a corporation in Panama (with bank account at a Panamanian bank), a nation that uses US dollars, by some miracle transferred half a trillion dollars into a bank in the US, the Fed would view it as an unplanned QE and would sterilize it by reducing its balance sheet (selling some bonds). But there is no equivalent capability at Bundesbank. Instead Bundesbank relies on "voluntary" sterilization as German banks with all the new deposits are reducing their net central bank borrowing (for example Deutschebank did not even participate in the LTRO program.)  The periphery central banks on the other hand are sterilizing their reduction in base money by lending into their banking system - see the blue text in the above table.

By the same process the collateral held at Bundesbank is decreasing, while the same at the periphery central banks is rising. The collateral therefore is concentrated in the German banking system (banks get it back when they repay their central bank loans) and is trapped at the periphery central banks (who take it in when lending to their banks) - exactly where it is not needed.

One concern is that base money would start growing rapidly in Germany when banks stop reducing their central bank borrowings. If trade deficits continue to widen, this becomes an equivalent of a QE in Germany and potentially a tightening in the periphery - exactly the opposite effect of what's required. If this were China, the central bank would simply issue a note and force German banks to buy it in order to soak up the excess liquidity. However, there doesn't seem to be a legal mechanism in the Eurozone to address this issue.

For further information on the topic, take a look at this paper by Hans-Werner Sinn and Timo Wollmershaeuser. It's a great reference.

TARGET2 Imbalances Paper

SoberLook.com

Eurozone citizens not benefitting from ECB's easing

The latest report from Capital Economics shows that the ECB’s easy monetary policy is not translating into improved credit conditions. The monetary base spiked after the ECB offered out the 3-year loans to the banking system.

Eurozone monetary base or "M0" (source: Capital Economics)

So far however this new liquidity is not being converted into any lending growth across the eurozone.  This can be seen in the weakness of M3, the broad money stock indicator.  But there are other signs of a difficult credit environment.  Similar to what happened in the US, loan growth to eurozone citizens has been dropping.  In particular growth in credit card lending has fallen off significantly.

Loans to individuals/households (source: Capital Economics)

Another sign of tightening credit conditions is seen in the survey of bank credit officers in the eurozone banking system. It shows more stringent credit standards - recent and projected.

Lending survey of credit conditions (source: Capital Economics)

And just as was the case in the US, banks are hoarding cash and depositing it with the central banks, as can be seen in the updated chart of the ECB Deposit Facility.

ECB Deposit Facility (source: ECB)

Given that liquidity provided by the ECB is temporary (overnight to 3 years - unlike true QE), it may be holding the banking system back from taking risk.  Sovereign debt is effectively "crowding out" private credit because banks still view it as a safer bet than industrial or consumer debt. And as long as they can make money on short term Italian government paper, why lend to an Italian household? 


SoberLook.com

The US quantitative easing has just begun

With the FOMC meeting currently under way, it's worth reflecting on the Fed's implementation of the monetary policy this year. Surprisingly, according to the latest Credit Suisse research, there hasn't been much quantitative easing in 2009. But how could that be possible, given the way the Fed has been growing its balance sheet? The chart below shows securities held outright by the Fed. How can this NOT be a form of quantitative easing?



Credit Suisse argues is that the monetary base has not really grown much in 2009, as the following chart shows.


Source: Bloomberg

So where is all the cash going from the Fed's purchases? It has to end up in the banking system and show up in the monetary base. The argument Credit Suisse makes is that all the short-term lending the Fed had put in place last year as an emergency measure has been shrinking in size, effectively offsetting the securities purchases.



Banks are de-leveraging, trying to reduce their borrowing from the Fed. Effectively securities purchases put Fed’s money with the banks, while the banks in turn pay back the Fed on their loans, thus neutralizing the impact. As we discussed before, this has slowed down the pace of the Fed's balance sheet growth significantly.



In addition some of the cash for the Fed's recent lending had come from the SFP program in which the US Treasury has issued treasury bills with the proceeds to be used by the Fed for its emergency lending. That type of program does not add any new cash to the system, because while the Fed injects cash (by lending to banks, etc.), the Treasury takes the liquidity out by selling bills. That in fact was the original purpose for SFP.

But SFP is expected to be wound down shortly. The impact of the reduction in short-term funding facilities will end as the programs come to a close. Therefore there will be nothing more to offset securities purchases going forward. That means that if the Fed continues purchasing paper at it's recent pace, quantitative easing finally will kick in with force.



This will end up ballooning bank reserves and truly “flooding” the system with dollars. The chart below from Credit Suisse shows their projection for reserves (translating into a rapidly rising monetary base):



The Fed is keenly aware of this problem going forward, particularly with the dollar weakness. Once SFP as well as the short-term facilities wind down, every dollar of purchased securities will be a new dollar “printed”. That is why the Fed is now supposedly putting together a new securities reverse repo program with the dealers. The idea is that going forward the Fed will be buying new securities by borrowing money from the dealers rather than “printing” new dollars. The Fed will place its securities with the dealers as collateral when it borrows. In fact the central bank may choose to borrow against the existing securities as well. New security purchases will be putting liquidity into the system, but by borrowing from the dealers, the Fed will be temporarily taking liquidity out.

Eventually the Fed will have to outright sell the trillion plus of securities it holds, taking liquidity out permanently (the reversal of quantitative easing) – a dangerous thing to do in this economy. And the more purchases it makes going forward, the harder on the economy it will be to reverse it. For now however, the reverse repo effort will have to do, by (at least in part) compensating for the wind down of SFP and the short-term emergency lending programs.

Negative interest rates may be a reality in Europe

The Bank of England is continuing on its aggressive path of quantitative easing.

From CNN:

The Bank of England announced plans Thursday to pump another £50 billion ($84 billion) into the UK economy in a fresh effort to steer the country out of a recession which it admitted had been "deeper than previously thought."

The surprise measure takes the total sum injected into the economy via government-backed "quantitative easing" to £175 billion ($294 billion).

There is talk of negative interest rates in the UK on deposits. But how’s that possible? Even Japan’s banks in the worst of times paid something on deposits. Well it already happened in Sweeden.

From the FT:

For a world first, the announcement came with remarkably little fanfare.

But last month, the Swedish Riksbank [Sweden’s central bank] entered uncharted territory when it became the world’s first central bank to introduce negative interest rates on bank deposits.

Some central banks are getting increasingly annoyed with the banking system that is not lending and seems to be completely paralyzed by fear. Yet all the quantitative easing and other stimulus has put incredible amounts of cash into the banking system. Many banks simply play it safe by depositing their cash with their central bank. That’s what the US banks have done.

Sweden’s central bank has had enough and told depositors that rather than receiving interest on their money, they would have to pay interest to keep their money with the central bank - thus a negative interest rate. And it shouldn’t be a surprise if other central banks like the Bank of England will follow in their desperate attempt to unclog the banking system.

Misreading the tea leaves of the money supply

An article written by Irwin Kellner (MarketWatch) proclaims that the Fed is actively taking liquidity out of the market.

Guess what? The Federal Reserve has not only stopped depositing copious amounts of liquidity into the economy -- it now appears to be in the process of making a sizable withdrawal.

Mr. Kellner argues that the evidence for such sudden action can be seen in the measures of money supply.

For example, the monetary base -- the raw material for the money supply -- has fallen at a seasonally adjusted annual rate of 8% from early April of this year through mid-August, after soaring at a 187% pace during the previous eight months.

A picture is worth a thousand words. Let's take a look at the monetary base:



There is no clear downward trend here. But even if there was a decline, the reality is that the Fed has little control these days over the monetary base. The bulk of this measure is represented by cash that banks deposit with the Fed. In the past the Fed did not pay interest on these deposits and banks only kept the minimum required amount there. The Fed could increase and decrease these requirements, thus controlling the money supply. But last year the Fed started paying interest on such deposits and the banks flooded the Fed with funds - depositing orders of magnitude more than was required. The banks were petrified of depositing funds at other banks, so a riskless deposit with the Fed was the best option. Now the banks use their Fed account as their piggy bank - they put money in and take it out as part of their cash management needs.

And even if this measure were to drop, it would just mean that banks are doing a little more lending. Sorry to disappoint Mr. Kellner, but the Fed has not been "making a sizable withdrawal", because the central bank has no control of the monetary base in this environment. The only way the Fed could influence what the banks hold with them is to set the rate they pay on deposits back to zero.

Mr. Kellner continues:

As a result, the Fed's two measures of the money supply, M2 and MZM, have begun to contract. M2 has shrunk at a 3% pace since the middle of June, while MZM, the St. Louis Fed's measure of liquid money, is down by 2% over the same period.

OK. Here is the M2 money supply trend broken into the M1 and the "non-M1" components. M1, which is physical cash and checkable deposits, has not moved down. The non-M1 component of M2 represents household savings deposits, time deposits (CDs), and retail money market funds. That component has dropped slightly.

>

Again, does the Fed have anything to do with the amount of household savings decreasing slightly? Maybe the Fed tells Mr. Kellner when to spend some of his savings, but the rest of us (at least for now) have control of what we do with our money. In fact the simplest explanation of the slight drop in retail deposits may have to do with Cash for Clunkers. People with some savings simply saw this as an opportunity to buy a car. And maybe (as controvercial as it may be) some people with savings are starting to buy homes.

Reading the money supply tea leaves and interpreting it as some sort of action by the Fed in this environment is pointless. Of course it is possible that Mr. Kellner has been adding something else to his tea.