The Fed’s Exit Strategy

This morning on financial TV before the Federal Open Market Committee's (FOMC's) scheduled announcement today at 2:15 eastern, someone (Larry Kudlow) asked "Should the Fed begin its exit strategy?"

Let me offer the view that it already has. The Fed's balance sheet ballooned last fall and peaked in December. Since then there has been no net new growth in total assets, but the composition of those assets have changed with circumstances. First, borrowing through special loan facilities grew rapidly, but the FOMC pretty much offset that by reduction in Treasury bills. The liquidity went where it was needed most without bloating liquidity throughout the system.

That special borrowing tapered off and has now diminished, but has been replaced with special assets such as commercial paper, mortgage backed securities, and consumer securitized debt, designed not to expand bank reserves and money but to unfreeze those markets and get them working again. Longer-term Treasuries have also been purchased to put downward pressure on longer-term interest rates, particularly mortgage rates.

People worry that purchasing longer-term Treasuries is "printing money" and is therefore particularly inflationary. Money is created when the Fed purchases assets, and it makes no difference in that regard whether it is long-term Treasuries, short-term treasury bills, or potatoes for the cafeteria. (Did I spell that right?)

While the total assets on the balance sheet first grew explosively and then flattened out, remarkably the growth of the M2 money supply has continued fairly steadily under the unusual circumstances. M2 growth has been faster than would be desirable under normal circumstances, but faster is appropriate when the velocity of the M2 measure of money has fallen. It's not money created that matters; it's money spent. Not money (M), but money times velocity (MV).

As confidence improves the velocity of money will presumably move back toward normal. It will not be difficult to see that and respond accordingly with slower money growth. Since gross domestic product equals money times velocity (GDP = MV) and since velocity equals GDP divided by money (V = GDP/M), a close eye on GDP growth is another way to see the need coming.

This is not rocket science.

Comments (1)

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  1. Fred says:

    Some have mentioned that GDP is a faulty measure of economic performance since losses are not counted against gains. For instance some natural disaster, among other things. Also there is no data that I am aware of that shows economic performance and absolute standard of living for different income groups.

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    Is anyone paying attention to desired job skills learned (or not) in high school?

    Would you care to comment?

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    Enjoy your blog and seeing you on TV.