Saturday, May 02, 2009

What is the Fed's "Stimulus Ratio"?

It's the magnitude of Fed manipulation with the money would it shock you to learn the stimulus ratio has been clocking historic highs over the past 12 months?

I'd recommend you check out this insightful article written by Paul Kluskowski, where he defines the stimulus ratio as the ratio of long-term rates to short-term rates.  According to Paul, the manipulation of this ratio, which basically composes the yield curve, is the means by which the Fed manipulates the monetary supply.

And it makes sense - the Fed has total control over short-term rates, but very little control over long-term rates.  And any control they can exert over long-term rates...such as, say, printing money to buy long-term US Treasuries to keep those rates low...can only go on for a limited amount of time.  Or so we believe.

Because banks borrow short and lend long, it's really easy for them to make money when short term rates are in the basement - as they are today.  Doesn't require a lot of brain cells when the deck is stacked in your favor like that.

Here's where it gets interesting - Paul says the stimulus ratio mostly fluctuated between 0.9 and 2.5 throughout most of the 20th century.  Anytime the ratio topped 1.15, it was fairly certain there would be a rally in the stock market.

Recently, this ratio peaked at 98 in November 2008!  And at the time of Paul's writing, the ratio still stands at 13!

Point being, we are clearly in uncharted waters economically, and all bets are off. 

Further recommended reading:

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