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Economic Outlook (Part 2) -- Monetary Policy

Part 1 (overview) of this series, which is taken from a recent presentation I made at UCLA, can be found here

Federal reserve monetary policy hasn't been this easy/accommodative since the inflationary 1970s. Short-term real borrowing costs are negative, a policy that is designed to erode the demand for money, expand the money supply, and push inflation higher.

The Fed has exploded its balance sheet in order to accommodate an explosion of money demand. If the Fed hadn't done this then we probably would have suffered from a deep recession/deflation.

The velocity of M2 money is likely to rise as money demand falls and confidence returns, boosting nominal GDP. Velocity fell sharply a few years ago as confidence collapsed and money demand soared. Things are just beginning now to reverse.

The growth rate of most measures of the money supply has averaged about 6% per year for many years. There is no obvious sign yet that the Fed's quantitative easing has had any impact on the growth of the money supply. Taken in isolation, this would suggest that the Fed's provision of reserves has been just enough to satisfy the market's demand for reserves and to accommodate a modestly growing economy.

The dollar is very weak—about as weak as it has ever been—and this reflects very accommodative monetary policy and deep concerns about the future of the U.S. economy.

Low real yields from the Fed and a very steep yield curve all but guarantee a continued recovery. Every post-war recession has been preceded by high real yields (tight money) and a flat or inverted yield curve.

Thanks to QE2, the fear of deflation has again all but disappeared. Inflation expectations now are close to the average of what we have seen in normal times.

The rise in Treasury yields poses no immediate threat to the housing market. Mortgage rates are still very low from an historical perspective. The combination of very low borrowing costs, rising real incomes, and a 35% decline in the real, average cost of housing prices in recent years has left homes more affordable than at any time in more than a generation.

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