Tight Money And Loose Credit In An Open Economy

Abstract

The U.S. Federal Reserve has been following a tight money policy, defined by growth in the quantity of money compared to nominal GDP growth since the first quarter of 2004. The Fed has also increased the federal funds rate 17 times in a row by August 8, 2006. Normally, this degree of tightening would be reflected in a slowing of real economic activity by mid-2006, with subsequent lowering of inflation pressures. Yet evidence of a slowdown only materialized in the second quarter of 2006. The housing sector illustrated signs of softening as the inventory numbers started to rise. Are there different factors influencing the effectiveness of monetary policy in this tightening cycle from prior tightening cycles in the Greenspan era? Our thesis is that the linkage between money and credit has become weaker in this cycle. Money appeared to be tight over the relevant time period, while credit was loose. Normally the two move in the same direction – when monetary policy tightens, credit conditions also tighten. But that didn’t occur until very late in the tightening cycle, as credit remained plentiful. Long term interest rates remained low, compared to prior tightening cycles over the cycle. This divergence, in the assessment of the authors, is due to three factors: 1) an increase in monetary base velocity, 2) large net inflows of capital into the U.S., in particular from the Far East – Japan and China, and 3) the expansion of the markets for securitized assets. Rising incomes and high saving rates in the Far East combined with a relaxation of international capital controls resulted in a flood of savings washing up on America’s shores. The securitization of bank-originated assets—originally home mortgages, but now including auto finance loans and credit card debt—has loosened the link between bank reserves and the level of credit in the economy.  These factors combined to explain why credit is loose in the U.S. while money appeared tight. A U.S. economy with these characteristics explains in part why the connection between domestic money policy and credit market conditions has been weakened.