The Fed versus Fear: A Status Report on the Economy

As I have noted in recent posts, any growth in the economy appears to be coming out of the consumer sector, with growth in revenues from live concert appearances and the astounding $805 million in payroll going to four New York Yankee players.

This strength in parts of the consumer sector, in an overall weak economy , falls in line with Austrian Business Cycle Theory. During a readjustment period in the economy, according to ABCT, the consumer-savings ratio readjusts itself to show greater strength in consumption versus savings (which would be reflected in capital goods purchases). But, how does this square with the likelihood that on January 8 when retailers report their sales for the month of December, they are likely to show a decline in sales in total of around 1 to 2%?

It squares because of other factors that occur during a readjustment period, in particular, the fear which leads many to hold on to cash. The spectacular growth in M1 is an indicator of just how much fear there is in the economy, as it has grown in recent months in excess of 30%. The desire to hold larger cash balances (as indicated by the growth in M1)in many ways has the same impact as a decrease in the money supply would have. A general deflation of prices occurs, which ultimately results in a lower overall price level. So what does this have to do with ABCT and the consumption-savings ratio. It means that if there is a strong demand to hold cash balances, which puts downward pressure on all prices, even if some consumer prices are falling, the consumption-savings ratio can still be readjusting in favor of consumption versus capital. It just means that even less spending is occurring in the capital goods sector and that prices are falling by larger amounts in the capital goods sector. And this is what is occurring, the prices of real estate and autos, for example, are dropping by much larger amounts than products in retail stores. This is also why we see dramatic declines in total sales in the housing and auto markets dropping by much larger amounts than the sales declines at retail stores. With this condition, the consumption-savings ratio is adjusting in favor of consumption.

All this being said, over the last two months the Fed as been increasing money supply (measured by M2 nsa) at double digit rates, which will again at some point push the consumption savings ratio in favor of savings (capital goods purchases).

Right now it is a battle between fear by the general public, which is holding on to additional cash, versus the Fed and its pumping of money. The Fed will eventually win this battle. It will mean a "recovery" (a movement towards the capital goods sector, i.e. the stock market, autos etc.) and overall climbing inflation, including that of consumer prices.

Although exact timing is always difficult, the recovery will occur much sooner than most expect. Certainly a lot sooner than those who are forecasting a decline in the economy that will last well into 2010. Indeed, any surprises in the economy will be on the upside. In the stock market, for example, we could very easily start with strong, very strong upside action immediately after January 1. Longer term, the Fed's mad money printing will result in record lows for the dollar, higher interest rates and very strong price inflation.