Why the Fed has no other alternative but to print money! (page 1 of 3)

In the past, I have demonstrated that economic growth and deflation is entirely compatible. The entire economic expansion of the US in the 19th century was a deflationary boom. Declining prices led to strong real income gains. As time went by, workers could buy with their incomes a larger and larger basket of goods because prices for consumer goods and commodities declined.

In other words, whereas inflation is the equivalent of a loss of purchasing power of money, in deflationary times the purchasing power of money increases. In deflation my 100 dollars today are worth more in a year's time since they will buy a larger basket of goods and assets, whose prices are declining. In my opinion, there is, therefore, nothing wrong about deflation. So why is the US Fed so concerned about deflation that Mr. Bernanke even suggested dropping US dollar bills from a helicopter in order to combat it?

There is one condition under which deflation is a disaster and this is when total credit market debt is high as a percentage of the economy. When debts are as large as there are now, deflating prices and especially deflating asset prices would wreck havoc in the economic system and lead to massive defaults and bankruptcies.

I may add that between 1950 and 1980 the debt to GDP remained largely constant. But after 1980, and in particular after Mr. Greenspan became Fed chairman in 1987, debt to GDP exploded. Therefore, it is not deflation that is the problem, but the preceding debt inflation for which the Fed's expansionary monetary policies are fully responsible. So, having created a monetary and debt monster, the Fed embarked starting 2001 in a huge money printing operation in order to avoid deflation.

Money supply tightening

Now, it is true, as my friends at Gavekal pointed out, that in recent times money supply growth has been decelerating. According to Gavekal, over the last six months, the US monetary base had been contracting, which is normally a sign that monetary conditions are actually tight. Usually such periods of a declining monetary base are followed by stocks not performing as well as cash, and frequently also by some kind of financial accident.

Now, I have no doubt that money has become tighter, which is also reflected by the US dollar strength since the beginning of the year. However, we should not overlook the fact that despite tighter money - the Fed fund rate has been increased from 1% one year ago to currently 3.75% - compared to nominal GDP growth and inflation, short term interest rates are still too low. In fact, at 3.75% the Fed fund rate is below the unofficial US inflation rate of about 5% and significantly below nominal GDP growth.

Moreover, observers of monetary conditions may do well not only to look at money supply growth but also at credit growth, which has in recent times gone through the roof! According to Doug Noland of www.PrudentBear.com, year-to-date, US bank credit has expanded by $544.7 billion, or 13.5% annualized. Among this total, security credit gained $145.6 billion, up 12.7% annualized. Commercial and industrial loans have surged at an annualized rate of 18.8%.

Real estate loans are up at an annualized rate of 16.7%. Year-to-date, asset backed securities issuance is up $ 451 billion, i.e., 21% ahead of the comparable period of 2004. Home equity loan ABS issuance of $286 billion is 24% above its growth in 2004's same period.

I may add that the 13.5% annualized credit growth generated only a 3.6% GDP growth.