I occasionally like to review the chart of the adjusted monetary base. You can view the shorter-term chart here. For a better look at what has happened in the last several years, you can view the chart here.
While there has been some zig-zagging over the last year, it is interesting to note that the monetary base is almost at the same exact level as it was just over a year ago when QE2 ended. So after the major explosion in the monetary base since the fall of 2008 through June 2011, the Federal Reserve has actually been in a tight monetary mode.
We constantly hear in the mainstream financial media about the possibility of QE3, we hear about Operation Twist, and we hear about the federal funds rate. But this stuff really doesn’t mean much right now. What does matter is the money supply that the Fed is controlling right now.
I like to use the adjusted monetary base because it seems to be the best indicator of what the Fed is actually doing. Right now, the Fed has stabilized the money supply and this could be a strong indicator for another recession.
Most of us who paid attention to the monetary base back in 2008 and 2009 would have expected significant price inflation to follow. But it hasn’t happened, or at least not yet. Something unique happened then that was not common at that time. The commercial banks actually increased their excess reserves way beyond the reserve requirements. Instead of loaning out all of this new money, they decided to park it at the Fed and earn a quarter of a percent of interest. This, along with the recessionary fears, helped to keep price inflation way down.
I don’t think the Fed is going to start QE3 (more money creation) for a slight downturn in the economy or stock market. The Fed has bigger fish to fry. They have to hold back right now in case there is something more serious that comes along, particularly another banking crisis.
If the Fed started QE3 now and then there was a banking crisis, then it would have to move to QE4 with the possibility of massive price inflation. The Fed officials would rather keep their powder dry for now and save their money creation for when it is really needed. They will bail out the banks before they bail out the whole economy.
If the Fed keeps its current monetary policy in place, I expect we will see another recession. The recession from 4 years ago was never allowed to fully happen. Since then, there has been a lot more misallocation of resources that needs to be corrected and flushed out. I suppose the big question at that point will be whether the Fed starts another round of digital money printing or if it allows a deep recession to occur. Hopefully it will be the latter, but I wouldn’t bet your gold on it.