The violent market reaction to the outcome of the Fed meeting is surprising. The Fed funds rate has traded consistently below 0.25% since early December while the quantitative measures described in the statement had already been announced or flagged in Chairman Bernanke's speeches.

The Fed’s recent interventions to boost credit flows and the money supply directly are warranted, although such action could have been taken without cutting official rates to almost zero. However, the risk that the Fed is creating the conditions for another upsurge in inflation needs to be recognised.

Deflation in the US in the 1930s and Japan in the 1990s was associated with a contraction of the broad money supply – see here. The chart shows annual growth rates of three measures of US broad money. None is near the danger zone. (M2 comprises currency, checkable deposits, small-denomination time deposits, savings deposits and retail money funds. M2+ adds large time deposits and institutional money funds, while the liquidity measure also includes Treasury bills and commercial paper.)

The Fed’s actions are already leading to an acceleration – M2 rose by an annualised 17% over the last 13 weeks. There is a good chance that the annual growth rates of all three measures will move into double-digits in early 2009. In the short term, this will provide important support to activity and reduce the (small) risk of the economy entering deflation but the price of success may be a renewed increase in inflation from mid 2010.

A previous post drew attention to a sharp pick-up in US narrow money M1 – currency and checkable deposits, adjusted for flows into sweep accounts. This acceleration continued in November, with the annual rate of change reaching 13%.

Broader aggregates are also now showing signs of improvement. Annual growth of M2 – M1 plus savings deposits, small time deposits and retail money funds – rose to a five-year high of 7.6% in November. Over the last 13 weeks M2 has risen at a 17% annualised rate – see first chart.

The M2 acceleration may partly reflect the Fed’s recent purchases of commercial paper – $312 billion since October – and plans to buy mortgage-backed securities should give a further boost. The latter initiative has contributed to a sharp fall in mortgage rates and a surge in refinancing applications – second chart.

Milton Friedman’s old rule of thumb is that the money supply leads the economy by about six months and inflation by about two years. The recent pick-up, if maintained, suggests the economy will hit bottom some time in early 2009, while fears of sustained deflation are unwarranted.

The effective exchange rate has fallen by 25% since July 2007. This represents the largest depreciation over 17 months in the history of the index (going back to 1960).

At various stages of this plunge Bank of England Governor Mervyn King has spoken approvingly of a lower exchange rate. For example, in a speech in January he stated:

If we are to raise our national saving rate without overall demand, output and employment suffering in the medium term, we will need to export more and import less. Such a rebalancing is helped by the fall in sterling’s effective exchange rate. Sterling has fallen, against a trade-weighted basket of currencies by almost 10% since August. And financial markets are pricing in a significant probability of a further decline in the exchange rate during this year.

During the press conference to present the November Inflation Report, when asked whether the large decline in sterling worried him, Mr. King replied:

Well clearly if sterling falls far enough this will be a concern and it will have an impact on inflation. I think it is not surprising that it has fallen over the past year...And that can be a helpful part of the rebalancing provided it doesn't threaten our ability to meet the inflation target.

Policy-makers’ comments arguably have little long-run impact on exchange rates. However, there is evidence that Mr. King’s remarks have had at least a short-term effect. The effective index has fallen by an average of 8 basis points a day since its peak in July 2007. Mr. King has given six speeches and presented at six Inflation Report press conferences over this period. The average daily change in the index following these 12 appearances was -50 bp. (This refers to the change on the day of his appearance when this occurred within trading hours or on the following day in the case of evening speeches.)

Mr. King’s view that a lower pound supports economic activity is questionable, particularly under current circumstances. British banks are dependent on overseas wholesale funding to bridge the gap between their UK-based deposits and lending. Net sterling borrowing from overseas stood at £162 billion in October, equivalent to 11% of GDP. Expectations of continuing sterling depreciation could lead to a withdrawal of this funding or an increase in its cost, thereby further tightening domestic credit conditions.

Markets are grappling with the issue of whether the bursting of the credit bubble will usher in sustained deflation, as occurred in the US in the 1930s and Japan in the 1990s. The answer will depend on monetary trends.

The onset of deflation in Japan was presaged by the annual rate of change of M2 turning negative in September 1992 – see first chart. M2 growth subsequently recovered but never rose above 5%.

When an economy enters deflation the demand for money rises, reflecting its appreciating purchasing power. To create “excess” money balances and reverse the falling trend in prices the authorities need to engineer a major acceleration in monetary growth. The Bank of Japan never achieved a boost on the required scale and the economy arguably never exited deflation.

In the interwar US, the annual rate of change of M2 was negative for almost five years between 1929 and 1934 – second chart. However, a major recovery ensued in 1935-36, with annual growth reaching a peak of nearly 13%. This succeeded in pulling the economy out of deflation temporarily before money trends slumped again in 1937-38.

US annual M2 growth was stable at about 6% between mid 2007 and mid 2008 and has recently moved above 7% – third chart. A broader liquidity aggregate including institutional money funds, large time deposits, commercial paper and Treasury bills is rising at a faster pace, of about 10%. The financial crisis has resulted in a rise in the precautionary demand for money but these growth rates appear incompatible with sustained deflation. (The latter should be distinguished from a temporary fall in consumer prices due to commodity price declines.)

Some commentators portray deflation as an inevitable consequence of the bursting of the bubble and monetary policy-makers as powerless bystanders. This is wrong. The Fed and other central banks are capable of expanding the money supply on whatever scale is necessary to prevent falling prices. The Fed has recently announced measures that will directly boost M2; the UK authorities must quickly embrace similar initiatives.

Industrial output in the G7 major economies fell a further 0.9% in October, bringing the cumulative decline from the peak in February 2008 to 5.3%.

The first chart below compares the current recession with the three largest prior output declines since World War 2 – 1974-75, 1980-82 and 2000-01. The current contraction is already greater than the fall in 1980 and may soon surpass the 2000-01 decline. Activity is, however, weakening less rapidly than in 1974-75, when output slumped 12% from peak to trough.

The chart shows that the initial slide in output was over after 12 months in all three prior recessions. This suggests the current decline may bottom out in early 2009.

This suggestion is supported by the recent behaviour of G7 narrow money M1 – currency and checkable deposits. The annual rate of change of inflation-adjusted M1 bottomed in August at -1.5%, recovering to 2.4% in October. A trough in this measure preceded the low in industrial output by seven months in 1974-75, three months in 1980 and 11 months in 2000-01. The average lead of seven months implies a March output bottom.

An approaching trough in activity should be signalled in advance by business surveys, which lead output by about three months. Purchasing managers’ new orders indices fell further in November, in some countries to record low levels. However, revisions to company earnings estimates by equity analysts correlate with business surveys and have become less negative in recent weeks – see second chart.

The ratio of household wealth to income is likely to have fallen by over 20% during 2008, reaching its lowest level for 10 years.

Net wealth – defined here as the value of houses and financial assets owned minus mortgage and other debt – amounted to £6.7 trillion at the end of 2007, or 7.6 times disposable income. Gross wealth was £8.2 trillion, of which housing contributed £4.1 trillion and direct and indirect equity holdings an estimated £1.8 trillion, while debt stood at £1.5 trillion.

An average of the Halifax and Nationwide house price indices fell by 15% between December 2007 and November 2008. Equity prices – as measured by the FT all-share index – were 35% lower at the end of November than at the close of 2007. These declines imply a loss of wealth of about £1.3 trillion.

Allowing for further growth in debt and a rise in income, the net wealth / income ratio is estimated to have fallen from 7.6 to 5.9 – a 22% decline. The largest previous annual drop was 21% in 1974.

The chart shows the ratio of net wealth to income along with gross wealth and debt separately. The recent loss is much greater than in the early 2000s, when housing resilience offset large equity price falls. The net wealth to income ratio hit consecutive record levels over 2004-07 but this year’s plunge has wiped out the entire rise since 2002.