Tuesday, January 21, 2014

Look Out! The Fed Is Doing Something Strange

Investment thesis:
Money growth has to a dangerously low level. Unless this is reversed in the next couple of months, it will show up in both growth and equity prices. Watch M2 growth.

Money growth has been declining for the past two years, as has velocity. Given the quantity equation, we know that when both money growth and velocity decline, nominal growth declines arithmetically (MV = NGDP). The Fed has been tightening for two years, resulting in declining inflation and nominal growth. You are not going to see real growth accelerate as long as nominal growth is declining. Declining money growth and velocity forecast a negative growth surprise for either 4Q13 or 1Q14, or both. The revised 3Q13 growth number was a fluke.

What is even more alarming is that money growth has declined sharply during 4Q13, and is now running below 5%--the slowest rate of money growth since the crash itself.

What is going on? Why has the Fed been tightening for two years, and why has the it allowed inflation to undershoot the target by such a wide margin?

Here is what the FOMC says on the subject: “To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens.” (Minutes, 18 Dec. 2014)

In other words, the Fed denies that it has been tightening. Someone should buy the Fed a subscription to its own database: it could be quite eye-opening. In seriousness, the Fed must be aware of what I have just observed. But why won’t the FOMC publicly address the issue? Shouldn’t the “most transparent Fed in history” explain to Congress and the people why it is tightening when it says it is not?

Investment Conclusion:
Whether the Fed knows it or not, money growth is dangerously low and falling. No one is minding the store at the Eccles Building. This means that we are in for a negative growth surprise for 4Q13, and for the stock market. In this case, bad news is bad news.

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