Liquidity Factors

With new bank concerns having surfaced regarding the sub-prime residential
mortgage market, it is timely to benchmark the various liquidity factors.

Monetary Liquidity -- Here we look at the building blocks of the basic money supply: Fed Bank Credit and the Monetary Base. The Fed has kept a tight rein on these composites for over two years to enforce the raising of short term rates and to maintain the current structure. Over the past year, Fed Credit has increased by 3.7% and the monetary base has risen but 2.2%.

Credit Driven Liquidity -- I use an M-3 analog to capture bank system funding. Since early 2005, this composite has increased from a twelve month growth rate of just under 5.0% to 9.4% through Jan. 2007. the major step -up in the growth of time deposit and commercial paper issuance has been to fund a sharp acceleration of commercial and industrial loans ("C&I"), but banking system real estate lending exposure has also continued to grow at a 10%+ rate as well. The slowing of the C&I sectors of the economy over the second half of 2006 resulted in reduced working capital requirements and has resulted in a flattening of C&I loan demand. It will be interesting to see whether concern over lending exposure to the residential mortgage market triggers a slowing in the growth of the banking sectors' real estate book. If the latter were to occur along with a more leisurely pace of C&I lending, funding requirements would slow, credit driven liquiditywould decelerate and the Fed might be forced to add more monetary liquidity to the system. A transition of this sort can be risky business for the general economy if the Fed delays too long.

Economic Liquidity -- I derive this measure from comparing yr/yr rates of growth of the M-3 analog with the $ cost of production growth. When the broad money supply grows faster than the $ cost of production, excess liquidity is generated in the system, and this excess can fuel speculation in financial markets where there is already positive interest. There has been a surge of excess liquidity since mid -2006, reflecting a modest pick up in broad money growth and a sharp deceleration of current dollar production growth owing to downticks in unit production growth and a sharp deceleration of inflation pressure. This development has no doubt helped the stock and gold markets, but since the money and production growth measures are dynamic measures, you have to monitor their interplay continually and be careful to watch for trend inflection points.

Trade Driven Liquidity -- This is a simple measure to monitor the gross dollar outflow from the US as a result of the trade deficit. When the dollar outflow is rising, it provides additional liquidity to the international economy and markets, and when it contracts, the opposite occurs -- all with a lag. The dollar outflow through the trade window remains very large but has not increased over the past fifteen months or so. This development suggests it is fair to temper one's thinking somewhat concerning international economic and market prospects.