Long Term Liquidity Trend

The Fed's tight management of the Fed Funds Rate during the Greenspan era belies enormous volatility in monetary liquidity. It is living proof of economist Art Laffer's judgment that you cannot consistently manage both the price and supply of money at the same time. Since the end of 1999, the Fed has been allowing one of the largest liquidity bubbles in US history to unwind. Much of the excess liquidity generated over the 1995 - 2002 period was burned off or consumed in the simultaneous crashes of the tech / telecom sector of the stock market and the economy. There has been enough liquidity spillover to give the housing market a good boost, but not enough to generate a serious general inflation.

Since the end of 2003, the growth of the real economy has consistently outpaced that of liquidity. The effects on the capital markets of the consequent substantial rise in the velocity of money have been muted by the continuation of a negative real short term interest rate. The bringing of the economy and liquidity into better balance has required considerable skill by the Fed and a fair measure of good fortune. Greenspan owed everyone this after the "banana boat republic" monetary policy he ran from 1995 into the new millenium.

Did the Fed lose its marbles over the 1995 - 2002 period? No, it worked with the Clinton team to engineer an economic and stock market boom that would provide a dramatic increase in revenue flow designed to put the US budget into balance. The effort was blessed by development of remarkable balance between economic supply and demand and a rising Dollar. But, alas, they lost control of the liquidity genie. It happened too fast, and the bubble was created. The budget went into surplus, but all hell broke loose anyway. The US went from soaring prosperity to the brink of economic depression in a mere half dozen years.

The US has moved back from the precipice, but there are tremendous challenges ahead, and the Fed must begin to work harder to maintain better balance in the execution of monetary policy. To this end, at some point, it must address the changes it made to reserve rquirements for jumbo deposits in 1992. It is still way to easy for the banks to evade the reach of the Fed by funding through jumbos with low or no reserve requirements. The latter is a technical but critical point. "Uncle Al" is in the home stretch of his tenure, and the Fed needs strong new command. I am hoping he keeps the monetary reins balanced to hand over to the new chief next year.