Aug 25, 2009, 9:29 a.m. EST
Early withdrawal

Commentary: The Fed is now quietly taking money out of the system

Comments 111
By Irwin Kellner, MarketWatch

PORT WASHINGTON, N.Y. (MarketWatch) -- Guess what? The Federal Reserve has not only stopped depositing copious amounts of liquidity into the economy -- it now appears to be in the process of making a sizable withdrawal.

A close look at quantitative measures of monetary policy reveals a sudden change in trend. After growing at unprecedented rates for well over a year, these aggregates stopped rising several months ago and have since declined, according to data provided by the Federal Reserve Bank of St. Louis.

For example, the monetary base -- the raw material for the money supply -- has fallen at a seasonally adjusted annual rate of 8% from early April of this year through mid-August, after soaring at a 187% pace during the previous eight months.

And after ballooning from $100 billion to nearly $1 trillion between September 2008 and mid-May, adjusted reserves have since declined at a 43% clip, to just over $800 billion.

As a result, the Fed's two measures of the money supply, M2 and MZM, have begun to contract. M2 has shrunk at a 3% pace since the middle of June, while MZM, the St. Louis Fed's measure of liquid money, is down by 2% over the same period.

Both had been rising by rates as much as 15% earlier this year. These are sharp enough changes over a long enough period to suggest that our central bankers are more concerned about inflation developing down the road than you might think, judging by their public statements.

And with good reason. As I pointed out in my column of Dec. 23, 2008, the Fed can't wait for all the stars to align or for the umpire of the business cycle, the National Bureau of Economic Research, to make the official call that the recession has ended. It must act long before if it is to prevent another burst of inflation.

The markets are already concerned about inflation. The yield curve has steepened over the past few months, while the spread between the plain vanilla 10-year Treasury note and its TIPS (Treasury Inflation Protected Security) counterpart has jumped from zero at the beginning of this year to 2 percentage points today.

To be sure, no one expects the Fed to hike interest rates anytime soon. But some forecasters think that by the second quarter of 2010, the effects of these reductions in liquidity will result in the federal funds rate rising above the top of the central bank's current target range.

This will mark the beginning of what could be a rather aggressive tightening of monetary policy. After all, it would follow a period of aggressive easing.

This V-shaped configuration for monetary policy is why I think the recovery will look like a W. ( See my column of Aug. 11.)

It is also a good reason to take some profits from the recent run up in stocks -- along with the fact that the two worst months for equities, September and October, are just around the corner.

Irwin Kellner is chief economist for MarketWatch, and is Distinguished Scholar of Economics at Dowling College in Oakdale, N.Y.

http://www.marketwatch.com/story/the-fe ... 2009-08-25