(How to) follow the money

Larry Kudlow
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Posted: Oct 23, 2003 12:00 AM

Some economic research services have stirred up the worry pot over recently sluggish money-supply growth. As the logic goes, the money slowdown reflects a liquidity shortfall from the Federal Reserve that could slow both the stock market and economic growth.

But this monetarist view hugely overstates the issue and misinforms the analysis.

Supply-siders know that the most liquidity-sensitive money measure is the price of gold, which has moved up from roughly $250 two years ago to around $370 today. This move reflects major Federal Reserve injections of cash, enough to end the deflation threat to both the economy and business profits. Prior to this reflation, the gold price had fallen from around $400 in 1996 to $250 in 2001. The accompanying deflation buried the great economic and stock market boom.

If today's slump in money growth were accompanied by a downturn in the gold price, then investor worries over inadequate liquidity would be justified. But this is not happening.

Other forward-looking price indicators confirm the gold trend. Various commodity indexes are rising at a 20 percent to 30 percent pace, and the dollar exchange value relative to foreign currencies has dropped about 25 percent over the past two years. So gold, commodities and the dollar are all telling us that the central bank is creating more, not less, liquidity.

The truest measure of Fed liquidity-creation comes from the consolidated balance sheet of the entire Federal Reserve System, published every Thursday night. This ledger of reserve bank credit consists mainly of the Fed's net purchases of Treasury securities. When the central bank buys a Treasury bill from a bank or a broker, it pays for it with new cash. This cash enters the economy. And when the Fed sells a T-bill to primary dealers, it removes cash from the financial system.

Over the past two years, following the Fed's post-Y2K liquidity crash, reserve bank credit has grown at a steady 10 percent.

While reserve bank credit measures the true liquidity supply, various other money measures track the transaction demand for money. Over short-run periods, money demand bobs up and down. For instance, the year-to-year change in the popular monetary measure know as MZM -- which tracks money that is readily available for spending and consumption -- has been holding near 8 percent for about 15 months, but it has moved well above and below this trend line over three-month periods.

A recent bobbing-down in demand may be attributed to mortgage refinancing. Refis have been drying up, which may be pulling down individual cash balances. If this is the case, the so-called money supply would also drop. Retail sales bobbed up this spring and early summer, but they now may be returning to a more sustainable trend line. This, too, could be a negative on money demand.

Still, liquidity-sensitive prices that trade in the open market are much better measures of money supplied by the Fed and money demanded by the economy. Market-price indicators like gold, commodities and foreign currencies -- because of the declining value of the dollar relative to each -- strongly suggest an excess liquidity position generated by the central bank. That's exactly the right solution to the prior shortage of liquidity that drove the deflationary economic slump.

Far more important than short-term swings in money measures like MZM is the recent and honest statement by Treasury Secretary John Snow that rising economic growth will bring higher interest rates during the next year or two. Not only did he seize the political high ground by linking an expected interest-rate rise to stronger capital formation -- rather than budget deficits -- he is also signaling acceptance of a stable or even stronger U.S. dollar as part of economic recovery.

This bow to dollar stability is far more constructive than a confrontational battle with Japan and China over artificially manipulating and repegging their currencies, a move that could lead to worldwide financial instability. Fortunately, that ill-conceived idea appears to have died at the just-completed Asia-Pacific Economic Cooperation summit.

Actually, a combination of accelerated domestic economic growth (on the back of lower tax rates and easier money), and the unbelievable rise in U.S. business profits and productivity, suggests the strong likelihood that both the dollar and real interest rates will in fact rise next year. This will all be part of the recovery process.

Hopefully, the Federal Reserve will let fast-forward real-time market-price indicators guide their future liquidity-setting and interest-rate-targeting policies. If the central bank keeps its eye on the right ball, it will remain accommodative to economic expansion, even while real interest rates rise in tandem with the coming investment boom.