The Fed’s monetary guns still needed in a weak economy

The past is history, yet only a few events are historic. Daily, I hear comparisons made of the economic recovery which began in the spring of 2009 to other historical cycles, and the complaints of weak growth that accompany those analogies.

Comparisons are easy. Recognizing why the events are unfolding in the fashion they do requires a bit more effort.The financial crisis of 2008 and the continued fear of financial risk it unleashed have been historic. In my opinion, the best evidence of that has been an approximate 30% decline in the velocity of money since 2008.

If the Federal Reserve were to have kept the monetary base fixed, then the combination of economic output and prices would have declined 30% to balance the equation: Money x Velocity = Price x Output. That would have been an outcome nobody would have wanted.

Historic times need historic measures, and the Fed’s bond buying program appears to finally be having the desired effect of getting money out from under the mattress and bank vaults and into areas of the economy where it can have the greatest effect on the velocity of money in the economy – autos and homes.

What we have seen over the past year is what this recovery has lacked all along: a sustained rebound in consumer durable demand. Large purchases increase the money flows throughout the economy due to the four or fivefold leverage associated with vehicles or home loans.

Unfortunately, the jump in durable sales is not a quick panacea for the economy. Unlike the past, rather than simply adding to economic activity, higher car and home sales and the new monthly payments they require have siphoned off some consumer demand for discretionary items. The evidence: for the past year most retailers have complained about weak sales, while home builders and new car dealers saw their best sales in over five years.

Fortunately, the slow economic recovery is not ending anytime soon, (despite the best efforts of the Government to derail it), and neither will the Federal Reserve’s resolve to support the economy as a 30% drop in the impact of money is rather large hole to fill.

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