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November 1, 2006 This is Tightening? Much has been made of the "tightening" by central banks around the world, particularly the multi-year "baby-step" therapy applied to short-term interest rates here in the U.S. This treatment was just concluded a few months ago under the watchful eye of Fed Chairman Ben Bernanke - the baby steps weren't the new Fed Chief's idea, but he is saddled with what they have produced. Having wondered what effect these rising rates have had on the creation of both consumer debt and new money, the construction of a chart showing all three laid together is a task that has sat near the top of the To Do list around here for some time. It can now be checked off.
The latest M3 data is available in reconstructed form at Now and Futures and John Williams' Shadow Government Statistics. The trend is still up - surprise! Household debt looks to be throttling back to a tepid sub-ten percent annualized growth rate - that might be expected after the orgy of borrowing since late 2002. Whether the recent pullback is a result of higher rates or sheer exhaustion by consumers is unknown. Surely there are limits to what Americans can borrow and spend. Aren't there? A Changing Relationship Looking back a few decades at the relationship between short-term interest rates and the growth of money supply, one change jumps out at you. Up until the mid-1990s, the two were located in about the same area of the chart, often times crossing over each other. That all stopped in the mid-1990s after the "productivity miracle", cheap energy, and other cheap imports allowed the two to become detached from each other. As shown in the chart above, there are now a good three to five percentage points, sometimes much more, between the two curves. The most recent data puts money supply growth at near ten percent with short-term rates fixed at just over five percent. Could that cause problems over the longer term? More significantly though, the old relationship between higher short term rates and lower money growth seems to no longer be working. This was a consistent pattern up until the mid-1990s - when interest rates rose, money supply throttled back. When money supply growth slowed, falling short-term rates caused money supply growth to head back up (sometimes with a lengthy delay). For the last ten years, and as shown clearly above for the new decade, higher interest rates seem to goad the money supply into growing faster until it declines for other reasons. The Dissenter Maybe Jeffrey Lacker at the Richmond Fed has seen a chart like the one above and walked away unimpressed with the effects of the rate hikes to date. Either that or he realizes that the Fed has to do a better job at appearing to "fight inflation", this being one of the more curious roles for a government agency - being responsible for combating something that they cause. Mr. Lacker has been the sole dissenting vote at the last three Fed meetings, favoring a quarter-point rate hike while all other voting members opted for a pause aimed at refreshing an ailing housing market. Like former Fed Chief Alan Greenspan, Mr. Lacker looks at some of the housing data and sees hope. On Monday he said there were "tentative signs emerging that the housing market may be stabilizing." After looking at weekly mortgage applications and recent home sales data, he commented "We'll just have to see. It's very tentative." What is decidedly not tentative is the booming new real estate sector of auctions. That is, selling real estate that has been turned back over to the bank and reduced in price for quick sale in former hotspots such as Colorado. Everything Seems Different Now With the bond market forecasting lower rates ahead and with the rise in short term rates failing to have the desired effect on credit creation and money growth, what's a central banker to do? The old relationships no longer seem to apply. If the intent of the last two and a half years of rate hikes has been to tighten things up here in the U.S. after the near death experience of the stock market melt-down that began in 2000, then something has gone horribly wrong. The levers and knobs don't seem to work anymore. This is tightening?
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