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By the end of June, the expansion
of the Federal Reserve's balance sheet is expected to come to an end.
According to economic commentators, Fed officials are expected to initially
hold the central bank's balance sheet steady — currently at $2.75 trillion
— by reinvesting the proceeds from maturing Treasuries and mortgage
bonds. Thereafter, these commentators believe, as economic activity starts to
gain strength, Fed officials are likely to shrink the size of the balance
sheet by selling assets.
Most experts and Fed officials are
of the view that freezing and thereafter reducing the size of the balance
sheet won't generate much of a disruption to economic activity as long as the
economy is on a sustained growth path. Most experts are also of the view that
we are currently on such a path.
Note that for most economists the
key is the strength of economic activity. Also note that the pace of economic
activity mustn't be too strong in order to avoid igniting inflationary
expectations and in turn the rate of inflation.
These economists attribute an
economic swing, i.e., a boom-bust cycle, to various mysterious factors such
as a sudden weakening in overall consumer spending and its subsequent effect
on businesses' economic activity. As long as the economy is on a sustained
growth path, various disruptive factors that cause boom-bust cycles can be
contained — so it is held. This means that what is
required here are capable Fed policy makers who will be able to successfully
steer the economy toward the growth path of economic stability. It hasn't
occurred to most commentators that the alleged defender of the economy
— the Fed — is perhaps the main source of economic instability.
We suggest that the key to
boom-bust cycles is the Fed's monetary policy. The so-called economy of Fed
experts' models is nothing more than monetary turnover that (once deflated by
a dubious price index) is labeled as real economic activity or real gross
domestic product. As long as the pace of monetary pumping is accelerating,
the so-called real economy follows suit. Once, however, the pace of pumping
slows down, the pace of the economy's so-called
expansion also declines (after a time lag).
Now as long as the state of the
pool of real savings is still OK, i.e., as long as there are enough wealth generators
to support wealth and nonproductive activities (bubble activities), Fed
policy makers can get away with the impression that they are helping the
economy. (Again, note that the more they pump, the larger the monetary
turnover and hence GDP becomes.) Once the pool of real savings becomes
stagnant — or worse, starts shrinking — the underlying real
economy (the true real economy) follows suit. In this case it doesn't matter
how aggressive the Fed's policies are: the economy cannot be revived. On the contrary,
loose monetary policies will only make things much worse by diverting real
funding from wealth-generating activities to nonproductive bubble activities.
Given the importance of real
savings in the revival of the true real economy, it is astounding that most
experts, including Nobel laureate Paul Krugman, are
of the view that there is a need for QE3 to keep the economy going.
We suggest that once Fed policy
makers freeze the balance sheet of the US central bank it will slow down the
growth momentum of the Fed's balance sheet. Consequently, this is going to
exert downward pressure on the growth momentum of the money supply. Note that
ultimately it is fluctuations in the growth momentum of the money supply that
set in motion fluctuations in the pace of formations of bubble activities. As
a result, various bubble activities that emerged on the back of the rising
growth momentum of the money supply will come under pressure — an
economic bust will be set into motion.
Obviously it is possible to have a
situation where commercial banks' expansion of lending "out of thin
air" counters the freezing of the Fed's balance sheet. It remains to be
seen whether this is going to be the case in the months ahead. For the time
being, the Fed's balance sheet continues to expand at a rapid pace.
So far in May, the yearly rate of
growth of the Fed's balance sheet stood at 16.9 percent against 14.8 percent
in April. Also, the growth momentum of our monetary measure AMS displays a
visible strengthening. Year on year, its rate of growth stood at 9.2 percent
in April against 7.4 percent in the month before.
 
Now, we suspect that the difficulty
the Fed has had in meaningfully "reviving" the economy so far could
indicate that the state of the pool of real savings or the pool of real
funding is in trouble. This means that even if the growth momentum of lending
does currently show some strengthening (see chart) it is highly unlikely
that, with the weakening of bubble activities on account of the Fed's
freezing its balance sheet, commercial banks will pursue an aggressive
expansion of credit out of thin air. Also, it is quite likely that with the
freezing of the balance sheet, Treasuries will come under pressure, and the
growth momentum of banks' holdings of Treasuries will weaken. This in turn will
exert downward pressure on the growth momentum of total bank lending, which
includes lending to the government.
Now, a visible strengthening in the
growth momentum of the consumer price index (CPI) and the core price index
(CPI less food and energy) may prevent Fed officials from introducing QE3 as
suggested by some experts.
The yearly rate of growth of the
CPI shot up from 2.7 percent in March to 3.2 percent in April. The pickup in
the rate of growth of the CPI is yet to concern Fed officials, including
Bernanke, who are of the view that this increase is of a temporary nature.
Some other experts have labeled the
strengthening of the growth momentum as tame; they believe it shouldn't be of
much concern. In fact most commentators are of the view that a little bit of
inflation is great news, because it provides a buffer against deflation,
which they regard as a terrible thing.
Most experts blame the increase in
the CPI on oil prices and various other components of the price index, which
they believe exert a temporary effect on the CPI. Nothing however has been
said about the lagged effect of past monetary pumping by the Fed.
Remember that a price is the amount
of money paid for a good. Hence, all other things being equal, it is not
possible to have a general increase in prices without an increase in money
supply. Based on this we can suggest that the yearly rate of growth of the
CPI is likely to strengthen further in the months ahead.
It will not surprise us if the
yearly rate of growth shoots up to around 5 percent by year end. Now even in
terms of the so-called core CPI, the rate of growth is showing visible
strengthening. The yearly rate of growth stood at 1.3 percent in April this
year against 0.9 percent in April last year.
We suggest that by year end the
rate of growth could easily surpass the unofficial target of 2 percent (see chart).
Conclusions
Most experts and Fed officials are
of the view that freezing and thereafter reducing the size of the US central
bank's balance sheet is not going to generate much of a disruption to
economic activity. We suggest that the key to boom-bust cycles is the Fed's
monetary policy.
We suggest that once Fed policy
makers freeze the balance sheet of the US central bank, the growth momentum
of the money supply will slow down. As a result various bubble activities
that emerged on the back of the rising growth momentum of the money supply
will come under pressure. A visible strengthening in the growth momentum of
the CPI may prevent Fed officials from introducing QE3 as suggested by some
experts.
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