The Federal Reserve currently has a tight monetary policy.  This tight monetary policy may speed up our way to a recession.  But this is as it should be.

If we get a recession, it is because of the previous loose monetary policy from 2008 to 2014.  It was a giant misallocation of resources.  A recession would be the market’s attempt to correct this.  That is why “correction” is a good term to use.

If the Fed kept a loose monetary policy, it wouldn’t make things better.  It would make things worse.  But it may delay the inevitable correction.  It will also make the correction more severe, thus more painful when it arrives.

When I say the Fed currently has a tight monetary policy, sometimes I get a quick retort to the effect of, “Yeah, raising interest rates up to a half percent is really tight.”  But it is a mistake to pay attention to the Fed’s interest rate – the federal funds rate – instead of paying attention to the money supply.

Since the banks hold well over $2 trillion in excess reserves, there is little need for overnight lending.  Therefore, the federal funds rate is almost meaningless in terms of the money supply.  The Fed did not have to severely deflate the monetary base in order to hike the federal funds rate.  It raised the rate paid on excess reserves, helping to put a floor under the federal funds rate.

I recently noticed that excess reserves held by banks had gone down quite significantly over the last few months.  They are down by about $300 billion.  Is this a sign that lending has increased and that massive price inflation is on the way?

But then I looked at the adjusted monetary base.  That is also down.  So the decrease in the Fed’s monetary base is down in correspondence with the excess reserves.

I don’t believe this is a result of the Fed selling off assets.  If it is, then the Fed is going against its own policy, which is to keep a stable monetary base by rolling over maturing debt.

The most likely explanation is an increase in reverse repurchase agreements, also knows as reverse repos.  Reverse repos are a tool used by the Fed to temporarily borrow deposits from depository institutions.  It has the effect of reducing the Fed’s assets.

When the Fed announced its hike in the federal funds rate in December, it notated at the bottom of the FOMC statement two ways it would do this.  One was to increase the rate paid on excess reserves from 0.25% to 0.5%.  The second was to increase the rate paid on reverse repos to 0.25% (25 basis points), which had previously been around 5 basis points.

I believe this change can explain the reduction in the monetary base and the corresponding reduction in excess reserves.  As long as these two pieces of data stay in line, then it means the money supply is relatively stable.  This means a tight monetary policy by the Fed.  It is not deflating, but it is also not inflating.

Since the easy money is drying up, the malinvestments from the previous loose monetary policy will be exposed.  We are going to get a correction soon unless the Fed changes course.

If the Fed starts QE4 and follows Japan with negative interest rates on excess reserves, then it might delay the recession.  Even with that, it may not be enough to delay it for long.

Timing the market is tough to impossible.  I am not trying to time the market precisely here, but some kind of a correction looks inevitable, whether it is beginning now or a year from now.  My guess is that it will start this year, if it hasn’t already.