Monday, January 10, 2011

Worth Reading

A speech given last week by Elizabeth Duke, a Federal Reserve governor who sits on the Federal Open Market Committee, is well worth reading.

She gives an extensive discussion of the prospects for economic recovery, jobs growth and inflation. These, of course, are key issues for traders. As goes the Fed, so goes the markets. And as go markets, so goes the trader's wealth (or lack of it).

I was especially fascinated by her remarks on the linkage between the amount of money in circulation and inflation. Doomsayers of the Congressman Ron Paul (R-Texas) variety have been saying that the dollar and the nation are in trouble because the Fed has created so much money to get a recovery started after the credit collapse of 2007/2008.

Gov. Duke said,

[T]he linkage between the level of reserve balances and the monetary aggregates in the current environment is quite weak.

You were probably taught, as I was, that the broad monetary aggregates increase when reserve balances increase because the larger volume of reserves supports increased lending, which in turn leads to a larger volume of reservable deposits.

While that argument might hold in normal circumstances, in the current environment excess reserves are many multiples of required reserves, and adding reserves is unlikely to spark a further increase in the volume of deposits.

As a result, the textbook linkage between reserve balances, bank loans, and transaction deposits just is not operative at present. Fundamentally, the levels of M1 and M2 are determined by the strength of the economy and the preferences of businesses and consumers for money, which depend on the yields on monetary instruments and competing assets.

Recent experience has again illustrated the difficulty in identifying a reliable relationship between reserve balances and the monetary aggregates. Even though Federal Reserve actions to fight the financial crisis and support the economic recovery added roughly $1 trillion to a base of about $43 billion in aggregate bank reserves, M1 and M2 rose at relatively moderate rates over the same period.

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