Shrinking Money Supply Dampens Inflation Fears


The soft economy and weak bank lending all but ensure the Federal Reserve will stick with its stimulative policies

The Federal Reserve stands accused of risking high inflation by recklessly printing too much money. But as Fed rate setters meet in Washington on Sept. 22-23, they won't see an excess of money sloshing around. Just the opposite. Paradoxically, the latest statistics show a shrinkage in the broadest measures of money.

The upshot: Members of the rate-setting Federal Open Market Committee are likely to announce on the afternoon of Sept. 23 that they are sticking with their stimulative monetary policy. Inflation, while always a risk, remains more of a long-term threat. The economy is so soft and the banking system is so weak that deflation remains a clearer and more present danger.

To fight the recession, the Federal Reserve has vastly increased the amount of reserves that banks have on deposit at the Fed. In a healthy economy, banks would take advantage of those reserves to increase their lending. Instead, they're hoarding the money, so the Fed's loose monetary policy isn't resulting in more loans. It's the process of lending that expands the amount of money in the economy.

"Disconcerting" Drop in the Money Supply

Paul Ashworth, senior U.S. economist for the economic consulting firm Capital Economics, says it's "disconcerting" that in August the broadest measure of money fell at an annual rate of 2.2%. That rate comes from comparing the amount of money in the three-month period of June through August to the previous three months. This broadest money measure, known as M3, is no longer officially published by the Fed but is tracked by private forecasters. It includes cash, checking and savings accounts, certificates of deposit, savings and loan deposits, and money-market funds.

In an interview on Sept. 21, Ashworth said the new information "basically legitimizes the approach the Federal Reserve has taken" by making it clear that, so far anyway, there's little risk of inflation breaking out from too much money.

So what can be expected from the Fed meeting? The rate setters are highly likely to leave the federal funds rate at its historic low of just zero to 0.25%. Internally there will probably be a vigorous discussion about when to start raising rates, but in its public statement the Open Market Committee is likely to reaffirm its commitment to keeping the federal funds rate at rock bottom for a considerable, unspecified amount of time.

Market professionals will be watching closely to see if the Fed says anything about its purchases of mortgage-backed securities, which are supposed to total $1.25 trillion by the end of 2009. The intent of the purchases is to buoy the housing market by keeping mortgage rates down. Richard Berner, chief U.S. economist of Morgan Stanley (MS), says there's a chance the Fed will announce it is stretching out the purchases into 2010. But Berner says it's more likely that the Fed will postpone any such announcement to the next meeting of the committee in November.

So, while lots of important discussions will occur behind closed doors, Berner says that as far as public pronouncements, this is likely to be "one of the least consequential FOMC meetings in the past two years."

Coy is BusinessWeek's Economics editor.

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