Risk Aversion Keeps Economy in Slow Lane

By KELLY EVANS

Federal Reserve has put its foot on the gas for the past two years. But the wheels that drive the economy are still stuck in the mud.

Further proof of this is expected Thursday with the Fed's weekly release of figures on the nation's money supply, whose growth is likely to remain anemic. That doesn't bode well for the economy's rebound prospects in the second half, especially in terms of job growth, even if it isn't necessarily heralding a much-feared double dip.

Historically, money-supply growth in the 5% range annually has provided support for real economic growth of roughly 3%. Yet, over the past year, the growth rate of the broadest official gauge of money known as "M2"—which includes cash, plus bank deposits and money-market funds held by households—has slowed sharply and even contracted during the first quarter of 2010.

This measure has since recovered a bit, but that isn't reason to break out the vuvuzelas. The velocity of money—or the rate at which money changes hands in the economy—remains weak by historical standards.

That distinguishes the current recovery from that of the early 1990s, says Northern Trust Chief Economist Paul Kasriel, when stronger velocity compensated for similar stalling in the money supply. This shows that "households just don't have the same appetite for risk and they're hunkering down," he says.

And isn't just borrowers who are risk-averse. Banks have curtailed lending. Commercial and industrial loans outstanding have declined for 19 consecutive months through May by a total of 24% since the October 2008 peak. This failure to multiply the money in the economy through lending counters the Fed's efforts to increase the money supply and boost growth.

The result, barring another round of stimulus, is that "from the third quarter onwards you get below trend growth again," says Lombard Street Chief Economist Charles Dumas. He adds that his firm's own broad money gauge, aimed at recreating a discontinued Fed measure known as M3, shows accelerating weakness. This even-broader gauge has shrunk by 5.3% in the twelve months through May.

Until the Fed's aggressive policies gain more money-supply traction, growth and employment are likely to keep spinning their wheels.

Write to Kelly Evans at kelly.evans@wsj.com