The rejuvenating effects from the shot of monetary adrenaline are fading. The surprise cut in the Discount rate on August 17 gave the patient a lift, but it looks like another dose is needed. In fact, it would come as no great shock to learn that increasingly larger dosages will be required for comparable if not diminishing results.
The futures market expects that more liquidity is imminent. Fed funds futures are now priced in anticipation for a 25-basis-point cut. The prospect of lower rates hasn’t been lost on forex traders, who have been selling the dollar with renewed gusto this month. Inspired by the outlook for lower rates, the U.S. Dollar Index looks set to challenge its previous intraday low from early August. If that floor gives way, the index will sink to lows unseen in more than a decade.
Meanwhile, the Fed continues pumping up the money supply at a healthy clip, as our chart below observes. M2 money supply was running higher by 6.3% on an annual basis for the week through August 13. By comparison, nominal GDP growth was pegged at roughly the same pace of 6.2% for the second quarter, based on an annual seasonally adjusted pace.

The question is whether the economy is poised to slow considerably, in which case a 6% rate of increase in money supply will look considerably higher in relative terms. Tomorrow’s update on Q2 GDP may throw out a few clues, although the official number for Q3 won’t be known for some time. That leaves no choice but to scratch around for signs in the lesser numbers about what comes next on the macro scene in the months and quarters ahead.
Judging by the bond market’s review of affairs, one can reason that a slowdown of some degree is coming. To be sure, the bond ghouls have been wrong before and there’s no guarantee that the fixed-income set’s forecasting powers are intact now. That said, the 10-year Treasury yield sunk to 4.53% yesterday, the lowest in more than a year. Right or wrong, the bond market foresees a rate cut and a sharp slowdown in GDP growth in the second half of this year and perhaps into ’08.
The stock market seems of a similar mind. The S&P 500 closed down 2.4% yesterday, erasing most of the bounce dispense by August 17 cut in the Discount rate.
Liquidity has been the solution in recent years to keep the economy humming. No less will be required going forward. So far, the liquidity boost has looked like a free lunch. But strategic-minded investors may see some value in taking a fresh look at the question of whether a free lunch can stay free indefinitely. As always, there’s a variety of opinion but only one answer.