I try to give updates and comments on the adjusted monetary base so that we can keep up with what the Fed is actually doing and not just saying.  I haven’t commented on this subject in detail for a while, mostly because there hasn’t been much change.  However, that in itself is a story in which we should pay attention.

You can view a short-term chart of the adjusted monetary base here:
http://research.stlouisfed.org/publications/usfd/page3.pdf

You can view a longer-term chart here and see the dramatic rise in the last 3 years:
http://research.stlouisfed.org/fred2/series/BASE

Now, here is a chart of the excess reserves held by banks:
http://research.stlouisfed.org/fred2/series/EXCRESNS

So what’s the story here?  Basically, the Fed has followed through on what it is saying.  QE2 ended in June, and since then we can see that the monetary base has been flat or even down slightly.  Meanwhile, the excess reserves being held by banks has an almost exact correlation with the monetary base.  This has been the case since the fall of 2008.  It does not seem that anything is changing here.

The Austrian Business Cycle Theory teaches us that loose money and artificially low interest rates will cause an unsustainable boom.  This boom will go bust when tighter money appears.  However, one thing that is important to note is that we do not have to see a contraction in the money supply to see a bust.  Just a slowdown in the growth of money can be enough to induce the inevitable bust.

The huge increase in the money supply over the last 3 years has been tempered by the huge excess reserves and a high demand for money.  This has kept a lid on price inflation.  However, it has still caused distortions in the market.  While we may not see a huge bubble like we previously saw in real estate or technology stocks, there are still certain sectors that have benefited from the monetary inflation.

Now that the Fed has been keeping the money supply fairly constant over the last 3 months, it will not be surprising to see a further downturn in the economy.  We are already seeing a flattening of the yield curve, which is an indication of recession.  It is unlikely we will see an inverted yield curve, but that is only because the short-term interest rates are already near zero.

This “bust” may show up in different ways.  We could see another increase in unemployment.  We could see the stock market crash.  We could see gold and oil go down further.  We could see housing prices go down further.  It is hard to say at this point what sectors will suffer the most, but we should not be surprised to see trouble ahead.

It is anyone’s guess what the Fed will do next.  However, if things get really nasty, it seems likely that the Fed will take further action and try to prevent the correction.  If the Fed starts a heavy dose of QE3, then we should expect a huge run in the price of gold at that point.  Stocks are a little harder to predict.

We will keep watching the adjusted monetary base and the excess reserves.  So far, the Fed’s actions have reflected its rhetoric.  The Fed is not creating new money out of thin air right now, so we should not be surprised by the lower prices in many asset classes.