You don’t have to be a pure monetarist to appreciate the economic power of the money supply. Yet, the vast majority of economists ignore money supply changes. Keynesians don’t even have money in their model. Instead, they focus on interest rates. Just listen to the parade of economists appearing on television; not one in a thousand ever mentions money supply.
On the other hand, Friedmanite monetarists believe devoutly that the velocity, or turnover, of money is always stable. This view is devoutly wrong. Over the course of a business cycle, velocity fluctuates wildly — especially changes in velocity. During periods of commodity deflation, such as the past two years, the rate at which money changes hands falls sharply as liquidity preferences rise. This robs money of its economic power.
Supply-siders, however, combine the message of market prices with shifts in liquidity; this is the best way to assess the economic impact of monetary policy. Market-based indicators such as Treasury spreads, commodities, and the dollar-exchange rate throw off strong signals about both the supply of and the demand for money. Actual monetary performance then punctuates the meaning of market price indicators.
Right now, both monetary indicators and market-based price indicators show that Federal Reserve policy has shifted significantly from liquidity recession to liquidity recovery. This shift towards liquidity replenishment is a huge plus for the stock market and the economy. In fact, it is the single most important factor in the recovery outlook.
Note the chart below. Both the adjusted monetary base growth and the market spread between two-year Treasuries and the fed funds rate have been moving higher all year. Base growth has increased from 3% to 11.5%, with the biggest change in the growth rate occurring since 9/11. Meanwhile, the two-year/fed-funds spread has widened from a 150 basis point inversion to a 150 basis point upwards slope, with the biggest change also occurring since 9/11. With commodity indexes stabilizing, steady gold, and a strong king dollar, all the key market-price indicators confirm that the period of liquidity deflation has come to an end.
This is the exact mirror image of 2000: when the monetary base was deflating, Treasury spreads were inverted and stocks were falling. This year’s recession was baked-in-the-cake last year by the Fed. Give credit where credit is due.
What’s increasingly clear now is that after 9/11 the Federal Reserve made a significant shift in their policy. Excess monetary scarcity has given way to an adequate monetary increase.
In the short run, nothing is more important to the stock market and the economy than changes in Fed policy. The stock-market recovery is an early indicator of the recent change in the thinking of Greenspan & Co. With a modest lag to allow the new money to change hands and circulate through the economy, economic recovery will follow the stock-market signal. Because the consensus of economic forecasters ignores money supply changes (and the price rule, for that matter), they are too gloomy over economic recovery prospects next year.