Last month, we saw what can happen when the assumptions imbedded in the marketplace turn out to be incorrect. Brexit created a roughly one-week period in which investors and traders sold, and then paused to recalibrate all of their spreadsheets and analytic tools. Now, nearly a month later, and aside from the price of the British pound, we are back to our usual tricks—mostly obsessing about Fed and other central bank policy moves.
It’s certainly been an odd couple of years in the market. Since 2008, equity markets in the U.S. have done very well. Paraphrasing literally hundreds of conversations with market observers and professionals: earnings aren’t really keeping up, and while the outlook is uncertain, the market sure is going up. Many of these people have warning flags posted but, to date, have not wanted to step off of a train heading uphill.
By now, most of us have seen the graphs and other analyses showing the nearly 1:1 correlation between equity market moves and the expansion in the U.S. Fed balance sheet. After all, asset price expansion is one of the stated objectives for the various forms of QE, ZIRP and nearly NIRP now. Stocks and housing prices have been compliant in this request. Japan has also been using these tools of policy in an attempt to boost its economy for over 20 years now, but without any real success. Good thing we’re following this model.
At the DailyPfennig.com, we’ve commented many times on how the Fed’s balance sheet expansion could be a real cause for concern. Will it create runaway inflation? Could it significantly undermine the value of the U.S. dollar? However, keep in mind how the velocity of money often stays quite low while potential feared results fail to surface during a policy initiative such as this.
State Money Versus Bank Money
In a related article by Steve Hanke, he presents some numbers (see Figure 1 below) along with a strong argument that the markets have it wrong.1 His thesis contends that the markets tend to focus far too heavily on state money, which is money created by the U.S. Fed, rather than money created and held by banks, or what’s called bank money. The latter is the money that is ultimately due to individuals and corporations. And it’s this money that would allow the expected impact of money supply creation to occur; loosely stated, this is bank lending.