Erik McCurdy | Jan 10, 2013 12:11AM ET
Following the financial crisis in 2008, the US Federal Reserve engaged in an historic liquidity operation intended to support economic recovery that continues today. Since the recession in 2008, M1 money supply has surged an astonishing 75 percent, topping the $2.4 trillion level in December with no end in sight to the extreme move higher.
You can lead a horse to water, but you cannot make him drink. You can force money into the system in exchange for government bonds, its close money substitute; but you cannot make the money circulate against new goods and services.
Consequently, the M1 money multiplier has remained below the 1.0 level during the last four years.
Federal Reserve Chairman Bernanke understands the dilemma, but he would prefer to deal with any problem except deflation, so he has committed to flooding the system with liquidity for the foreseeable future and worrying about the consequences later. In fact, he has even admitted that his intention is to inflate risky asset prices.
Recall that when the second quantitative easing program was introduced in late 2010, Bernanke stated in no uncertain terms that one of the primary goals of the program was to inflate the stock market. The following quote is from an article written by Bernanke and published in the Washington Post in November 2010:
Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. … And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.
There is no question that the measures taken by the Federal Reserve during the last three years have fueled appreciation in the stock market, so, from that perspective, the programs have been a success. However, it must be noted that equity gains fueled primarily by government stimuli can be erased as quickly as they are created. The liquidity operations that have produced the huge spike in M1 since 2008 have created massive structural imbalances that will continue to drive violent moves both higher and lower as the system attempts to return to a state of equilibrium.
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