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ONE OF THE IRONIES OF MONETARY POLICY as it is currently practiced is that it has little to do with money.
While lip service may be paid to something called the money supply, the Federal Reserve and its cohorts actually fiddle with interest rates in attempt to set the economy on a blissful course of full employment and stable prices.
But money still matters, even if policy-makers ignore it.
Indeed, four years ago the Fed ended tracking the broadest measure of the money stock, known as M3. To fill that gap, John Williams Shadow Government Statistics (www.shadowstats.com) estimates M3 from published sources as part of his mission to strip away the obfuscation prevalent in many government economic statistics.
The Fed still publishes the narrow measure of money, M1, consisting of currency and checking deposits; M2, which adds consumer savings and money-market accounts, and MZM, or Money of Zero Maturity, which includes M1 plus other accounts with check-writing privileges, such as money-market funds.
But M3, which takes in savings and institutional deposits, arguably is a superior measure of the liquidity in the economy. During the credit bubble from mid-2005 to the beginning of 2008 (just when the Fed stopped publishing M3 data), the broad money measure soared, attesting to the gusher of liquidity evident to all. The official M's failed to reflect the massive liquidity expansion during that time.
Now, Williams writes, SGS' estimate of M3 is signaling the opposite; it is shrinking in real terms, that is, after adjusting for inflation. That's happened only four times before last November, and each time it signaled either the onset of a major recession or a sharp deterioration in a contraction already underway.
"Not all economic downturns are triggered by liquidity crises, but all liquidity crises trigger or intensify economic downturns," he asserts.
The notion of a tightness in the money supply seems to fly in the face of all the "money printing" by the Fed since the intensification of the credit crisis in the fall of 2008. But what the Fed supplies is the monetary equivalent of crude oil to the economy, which actually runs on the refined product analogous to gasoline -- money and credit supplied by the banks. And it is those banking "refineries" whose output has been lagging, resulting in a now-shrinking broad money supply.
Based on currently available data, SGS estimates real M3 in December is down 3.2% from a year earlier. Before adjusting for inflation, nominal M3 is down about 0.7%, only the second year-over-year decline since modern reporting of the aggregate began in 1959.
And, so what? When the year-on-year change in real M3 turned negative, non-farm payrolls turned down on average six months later. In 1970, the lag was nine months; in 1974, seven months; 1981, two months, and 1991, six months, according to SGS.
Williams looks for the consensus forecast for continued recovery "to get battered by unexpected weakness in such series and retail sales, housing, industrial production and employment in the next several months."
Current key indicators are looking rosy, with Institute for Supply Management's manufacturing purchasing managers' index hitting its highest level last month since 2006. The consensus call for December's non-farm payrolls is for no change with some economists actually looking for an increase.
But Williams sees the die having been cast for a double-dip in the recession -- contrary to the assumption of a resumption of growth that underlies everything from the fiscal projections of the federal government to the soundness of the banking system.
Other problems also loom for the housing and mortgage sectors.
The back-up in long-term Treasury yields is pushing up fixed-rate mortgage rates for the last five weeks of 2009, the longest streak of increases last year, according to Bankrate.com. The Fed is slated to wind up its program of $1.25 trillion in purchases of mortgage-backed securities at the end of March, which could add to the upward pressure on home-loan rates.
At the same time, resets of so-called option adjustable-rate mortgages are set to surge in 2010. The volume of resets of option ARMs this year could rival those on subprime loans in 2007, when those borrowers started to get into trouble.
And housing sales are likely to slow once the popular tax credits for buyers expire this year. Tuesday, the National Association of Realtors reported pending home sales plunged 16% in November when the tax credit for first-time homebuyers originally was slated to expire. (Prospective buyers would have had to signed contracts earlier in order to close in time for the original Nov. 30 deadline for the credit.)
That shows what's likely to happen once government subsidies in the form of tax credit and Fed support for the mortgage market end.
Even ignoring the still-fragile housing market, a contracting real money supply has always portended a downturn in the economy. And after taking these special factors into account, the outlook is even more precarious.
Comments: randall.forsyth@barrons.com
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