Academic journal article ABA Banking Journal

Parallel Universes

Academic journal article ABA Banking Journal

Parallel Universes

Article excerpt

WHILE THE ECONOMY CONTINUES to run full steam ahead, the financial markets have been sending out troubling signals. How can the financial markets' funk coexist with a remarkably healthy economy?

Some economists started looking for a "soft spot" last spring, when the Fed was about to start raising interest rates and paranoia about a China slowdown trashed the commodity markets. Instead, jobs and income have steadily improved and China has continued to grow at a 9%-plus pace. The U.S. economy, which had been buoyed by aggressive fiscal and monetary stimulus, transitioned to a self-sustaining economic expansion.

But some financial indicators have been weakening since the Fed began to withdraw stimulus a year ago, including weakness in growth of the money supply and global dollar reserves. While some of the recent weakness in the U.S. money supply stems from unusually strong seasonal flow of federal taxes, it is true that liquidity growth has decelerated. The smaller fiscal deficit and decelerating liquidity growth are the natural result of firming Fed and fiscal policies. The withdrawal of policy stimulus is necessary because the private sector has kicked in strongly and government stimulus at this stage of the cycle raises the risk of inflation, now in a cyclical upturn.

The deceleration of liquidity growth is the primary force behind what's ailing the financial markets. When the Fed cut the funds rate to 1% in June 2003, it encouraged people to borrow and short the dollar to finance all kinds of higher-yielding investments around the world. …

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