A few weeks ago in my commentary, "Re-Thinking the Fed's Exit Policy" I said the next move of the Fed should be to ease monetary policy, not exit or tighten. The Fed is now in the process of doing a 180 degree pivot. On July 21, Ben Bernanke testified, by one journalist's account, ten sentences to one on the Fed's exit plans compared with the prospect of quantitative easing. One week later James Bullard of the St Louis Fed, called for quantitative easing. On Tuesday, August 10th, the day of the Fed's meeting, the Fed confirmed its intention to possibly ease by buying treasuries and not allowing its holdings to run off which would amount to a contraction of the money supply.

The "new normal" and the new plan is to leave the two trillion dollars created by the Fed in the system, as a benchmark. Any money created above and beyond that figure by the Fed is an easing of monetary policy. Any money reduced from that figure is a contraction. That is exactly the right thing to do.

The way I always try to view monetary policy is through the eyes of what would occur given a gold standard. Since the gold standard was successful for many centuries, it is in my opinion, the best standard by which to judge what is happening today. You must remember the American fiat standard was a new experiment launched a hundred years ago, to replace the time tested gold standard. We are still experimenting with it to this day.

Under the gold standard money flowed into the system by virtue of gold production. Through hell or high water, money supply was fairly consistent over the centuries. In no case did the money supply contract. That would be abnormal. Through booms and busts, money supply stayed constant at about 2 to 3% increases per year, with a few exceptions such as new major gold discoveries.

If and when there were new gold strikes, money supply would increase dramatically, prices would rise, the market would adjust to the new price level, and markets and prices would quickly return to stability. To say that the Fed should not be increasing the money supply is to defy normality. A fiat standard should at least attempt to mimic a gold standard. It does not at its own peril -- and ours.

But what many are saying today is that we should maintain a zero monetary growth policy; or worse, to contract the money supply. What is being confused is the difference between reserves and money supply. They are not the same thing and do not act on the price level in the same way. Those who are advocating reducing reserves are actually advocating reducing capital. Yet, most would agree that one of the primary causes of the credit crisis was too much leverage, which is to say too little capital. The banks by holding the newly injected reserves are doing voluntarily what many are advocating they do by law -- increase capital requirements.

In my article, which you can access in the Kitco archives, I said I was very concerned that the Fed would try to return to the level of money supply prior to the crisis.

"This, I believe could be a huge mistake. There is an example of this in history that provides a valuable lesson.

During the First World War, England was on the Gold Standard. It suspended gold convertibility and pursued inflationary monetary policies to finance the war. After the war it tried to return to the Gold Standard by reducing the money supply and return to the price level of pre-war days. It tried to fix the Pound in terms of gold at the previous price. The experiment failed miserably. The Gold Standard got the blame as the nation was thrown into depression. This mistake was responsible for England abandoning the Gold Standard which it had adhered to, more or less, since the 14th century. In many things monetary, you cannot go back. I believe this is the case now."

The Fed's decision to allow the market to adjust to the two trillion dollars injected into the banking system rather than to withdraw it is a wise one and avoids the mistakes of the past. By the Fed focusing on its balance sheet, we all can focus on its balance sheet. This transparency allows the market to see the degree of increase or decrease in the money supply.

You will hear a lot of economists and commentators talk about monetization, inflation, and the threat from the Fed. But the proof will be in the money supply figures and the price indexes of this country. Price rises will not occur across the board in this country until money starts to progressively chase goods and services. For those of you that are tempted to yell that the Fed is inflating, here is your problem:

Here is M1 In billions as supplied by the St Louis Federal Reserve:

2009.06.29: 51721.8

2010.07.19: 851698.9

M1 is cash on hand plus checking account money. Money has not entered into checking accounts. Money is not chasing goods. If at some point it does, the job of the Fed will be at that time to perhaps reduce the increase in the rate of the growth of money to reasonable levels. But not until then.

The whole notion of an "exit policy" was to be in response to that possibility. Fair enough. But that is not what happened. Instead, M1 growth has been zero. The problem has not been too much money chasing too few goods; it has been very little money chasing any goods.

Instead of the Fed pursuing a low, stable, non-inflationary monetary growth policy, it is pursuing a zero growth monetary policy. This is dangerous and dysfunctional. Inflation has been cut in half in the last year, long term interest rates fell from 4% to 2.7%, and the GDP is trending progressively lower.

How do you say tight money?
Even with the massive increase of reserves injected by the Fed we are trending towards a recessionary/ deflationary bias in the economy. The Fed needs to inject a constant 3-5% increase of funds into the banking system. It needs to expand M1. The two trillion dollar benchmark needs to increase weekly and monthly at normal levels. To the degree it does not, we will likely see a continuation of all the downward trends already in motion.

And even with a resumption of normal increases in money growth, they are too late to prevent the damage to the economy already done. The Fed's consistent focus on reducing money growth over the last year has contributed to the decline of the economy we see today.

It is not the Fed's job - or even within its ability - to create economic growth. Only freedom and discipline can do that. All the Fed can do is to create a level playing field in the sphere of monetary policy. That policy should be a low and stable growth of the money supply.

Let me stress that the Fed's actions are neutral at this point. They have not yet increased the money supply from a year ago. All they have done is open the door to the potential of increases. The money supply figures in the future will tell us whether they actually ease or not. The fed cannot create growth. But it can retard it. Its zero growth monetary policy of the last year is exasperating the recessionary/deflationary tendency's already in motion. It needs to cease.

Paul Nathan