Spiga

Easy money is GOING away...

The cycle of cheap money that has fueled the booming financial markets of the last 20 to 25 years is coming to an end.

Are you and your portfolio ready?

From January 1980 to January 2005, M1, the Federal Reserve's most conservative measure of the money supply in the United States, grew by 252%. M3, a measure that captures some of the money created by Wall Street's institutions, grew 420%. At the same time as the money supply was growing, the cost of tapping into that river of cash was falling: The Fed funds rate, the cost for a bank to borrow overnight from the Federal Reserve, fell from 13.8% in January 1980 to 1% in January 2004.

But now, that cheap-money cycle is over. After hitting a low of just 1% in the first half of 2004, the Fed has hiked its target for the Fed Funds rate to 2.75%. Reading between the lines of the Fed's press releases, I think it likely intends to take its target up to 4% to 4.5% by year end. That's the level economists see as "neutral," meaning interest rates are neither so low that they stimulate the economy nor so high they put the brakes on growth.Need a broker?
Go to MSN Money's
Broker Center.

And growth in the money supply has started to taper off, too. After growing by 11% from 2001 to 2002, growth in M3 dropped to 7% in 2002, and then to 4% in 2003, before kicking up again slightly to 6% in 2004. For the three months from November 2004 to February 2005, the annualized rate of growth has dropped further to 4.2%. That's a level near the growth rate for the economy during the last quarter of 2004 (and therefore roughly "neutral," since the growth in the amount of money in the economy is approximately equal to the growth in the size of the economy as a whole).

So what happens now?

The bulls believe the Fed will be able to engineer a gentle transition from the cheap-money economy to a "neutral"-money economy. In this scenario, short-term interest rates will rise gently -- just enough to keep inflation under control -- to somewhere around 5.5% in 2006. The economy will grow at 3% to 3.5%, a level some economists call its natural rate of growth based on U.S. population growth and U.S. productivity improvements. Corporate earnings will climb 7% to 10% a year, thanks to improved cost controls in the new, leaner U.S. corporations. And all that combined will keep the stock market chugging along with annual returns in the neighborhood of 8%, give or take two percentage points or so.

The bears believe the bulls are hallucinating. You can't grow the money supply at rates like these -- 77% growth in M3 for 1980-1985, for example, as the Fed tried to boost the economy out of the dumps -- without creating serious structural problems in the economy and financial markets. Cheap money has inflated the value of assets -- stocks, bonds and houses -- and the end of cheap money will result in the collapse of those prices. At the same time, all that money chasing a limited supply of goods and services must result in inflation, they argue. The Fed, they believe, has seriously miscalculated by waiting too long to begin to raise interest rates and then compounded that error by raising rates too slowly.

What do you think will happen?

0 comments:

footerads