Money, money, money

Past hard landings for the U.S. economy have often taken place when monetary policy is tight. This does not seem to be the case now. The Fed began cutting rates nearly five months ago and real rates (i.e., adjusted for inflation) are below zero. This applies to the fed funds rate and to nearly the entire U.S. Treasury curve. It is not just the price of money that suggests a loose Fed policy, but also the supply of money (M2), which has accelerated in recent months.

The money markets, which had experienced a major disruption, are gradually and haltingly recovering. The yield spread between U.S. T-bills and the London Interbank Offered Rate (LIBOR) has tightened dramatically. In late January, the three-month spread was near 105 basis points (bp) from a peak in mid-September of 160 bp. The spread averaged just below 40 bp in the first half of 2007.

The three-month LIBOR rate has sustained a break below the fed funds yield for the first time since mid-2003. In addition, the beleaguered assetbacked commercial paper market that contracted sharply in the last third of 2007 grew steadily though January.

The premium that U.S. investmentgrade corporations have to pay on top of Treasury yields has trended higher: At around 330 bp on some benchmark industry indices, the premium is the highest since late 2002. However, because of the tremendous rally in Treasuries, the absolute yield that corporate America has to pay has fallen. In the two weeks up to Jan. 18, investment grade corporations raised $50 billion in bond sales at the lowest yields since last April.

The U.S. dollar remains weak, even though it has stabilized in recent weeks against most of the major currencies. According to data from the Organization of Economic Cooperation and Development (http://www.oecd.org), the U.S. dollar is well below its purchasing power parity level, which is the level economists say currencies gravitate to in the long run. The OECD calculation suggests the euro is overvalued by as much as 27 percent vs. the dollar, and the British pound is almost 30 percent overvalued. By this measure, the dollar is about 14 percent undervalued against the Japanese yen.

U.S. exports have been expanding at a double-digit year over year pace, with only one exception last year (February). In recent quarters, the net export function has contributed nearly as much to U.S. growth as residential construction has subtracted from it.

While leading economic indicators have fallen for three consecutive months, the coincident indicator (a measure of contemporary conditions) rose in both November and December after being flat in October. This would suggest that if the U.S. economy is contracting, it did not begin to do so in December. And thus even before the purported economic contraction began, the Fed had slashed interest rates by 100 bp in the last four months of 2007 and delivered a dramatic 125 bp cut in the month of January.

Although there has yet to be a final agreement, the government is moving toward authorizing a fiscal stimulus package which, as currently constructed, may help boost the economy at the margins in the second half. (There have been some reports that the Senate may not be fully aboard the White House-House of Representatives deal, but given the political cycle, the risk seems to be for a larger package rather than a smaller one.)