A note about money supply

- by New Deal democrat

An initial note: I read all of the comments. I don't always respond because frequently I simply don't have time. As it is I probably only write about half the posts I'd like to. In that vein I haven't been able to flesh out my take on the whole "double dip" issue, which basically is that the most likely near term scenario is that we are going to have just barely positive growth, or just barely negative contraction. While the former is certainly preferable, I can't see getting too excited about which semantic term winds up being the most accurate.(As to why, see Dean Baker this morning). As we surely already know, not all recoveries and not all recessions are created equal. Anyway, I wanted to address briefly a matter that came up in the comments.

Every week I include in my list of high frequency indicators a paragraph about money supply. That real M1 and/or M2 are important and leading indicators for the economy as a whole goes back at least as far as Milton Friedman's and Anna Schwartz' "A Monetary History of the United States" which won him the Nobel Prize in Economics. You don't have to agree with his politics to accept that he was on to something important. As I've pointed out many times, there have not been recessions without real M1 turning negative and also real M2 being under +2.5%. Here's the longest-term graph available from the St. Louis FRED:



As you can see, in the last couple of months, both real M1 and real M2 have been soaring. In the last few weeks (over a month after it became apparent in the weekly data), there has been a debate about the meaning of this trend. I've referred to it as a "panic" by which I mean an emotional move, not necessarily negative.

Friend of the blog Prof. Jeff Miller of A Dash of Insight, considers the term inappropriate:

There is finally some commentary, centering on the idea that M2 growth reflects panic and a desire for cash. Putting aside the complete lack of correlation between M2 growth and any measure of panic, you might expect panic to show up in brokerage accounts (MZM), bond purchases, or gold purchases rather than M2. This is another example of where some are willing to throw out the entire body of Milton Friedman's work because they think that "this time is different." Do such pundits really believe that there were no other "panics" in the history of the M2 series? My advice is to ignore cheaters who spin current data without reviewing the entire series.

Scott Grannis, a/k/a the Calafia Beach Pundit, takes the opposite view:

The issue is the surge in the M2 measure of money supply .... [I]f the extra growth in the money supply results from extra demand for money, then this is ... a reflection of some other problem that is driving people to increase their holdings of dollar liquidity.... [I]t appears that the rapid expansion of M2 in recent months is part of the fallout of the eurozone sovereign debt crisis that is in full bloom. Money is fleeing Europe and seeking safety in the U.S.

Grannis' view appears to be strongly supported by Kash Monsori:

European banks are shifting their cash assets out of European banks and putting much of them into US banks. (An interesting question is what European MFIs have done with the remaining money they've withdrawn from the European banking system... but that's a story for another day.) This has happened at a significant rate, with a net transatlantic flow from European to US banks that probably totals close to half a trillion dollars in just six months.

If you're wondering exactly who has been the first to lose confidence in the European banking system, look no further. It seems that at the forefront is the European banking system itself.

Rebecca Wilder at Angry Bear dissents:

I respect Kash's work; but it's my view that he jumped to some inaccurate conclusions on European bank flows. The data demonstrate that European bank branches in the U.S. are more likely moving capital back to their local branches, rather than into their U.S. branches.

Wilder views the surge in money supply recently as simply the outcome of QE2.

Whether the surge is emotionally based or not, the fact is, it is happening. In fact the present surge in real money supply looks like nothing so much as the similar surge in September and October 2008, when the US financial system was on the verge of total meltdown, as seen in this close-up of the above graph, covering the last 4 years:



It is generally thought that the effect of money supply is seen with a lag, on the order of a full year. If so, then the move into M1 and M2 money in September and October 2008 was both a coincident reflection of panic, and a leading indicator of the recovery that began in the 2nd half of 2009. Panic or not, I see no reason to partake of that most common route to error, that "this time it's different."

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Money Supply: We're DOO ... oh, wait ...

- by New Deal democrat

A few months ago it was fashionable, pace Zero Hedge, to note the discontinued M3 money supply series, which was "crashing" in YoY terms. We were told that this big a collapse hadn't been seen since the 1930s. (Of course, we might counter with the fact that it's a good thing that less credit has been created compared with the fog-the-mirror loans of the recent past, but why get in the way of a good story?).



A current proxy for M3, we were told, and I agree, is MZM (total money supply from all sources). Now, one slight problem is that M3 (and MZM as well) tend to peak towards the end of or even after recessions, and bottom well into the ensuing expansion:


In fact, the Fed discontinued M3 because it did not believe it carried much utility, as real M1 and real M2 have a much better record forecasting economic activity in the near future, and M3's essential components are captured by MZM above. In fact, there has never been a recession, including the Great Depression, where real M1 wasn't negative YoY, and real M2 wasn't less than +2.5% YoY. That's why, as you know, I track both real M1 and real M2 weekly. Here's a graph of those two series going back 50 years (in the below graph, I subtract 2.5% from M2 so that the "danger line" for both is zero):



Hence my weekly report that M2 is in the danger zone but improving, and M1 is not and has not been in the danger zone all year.

So what is happening now? Sure enough, M3 looks like it may have bottomed on a YoY percentage basis:


And MZM? It is now positive again YoY:


I'm sure Zero Hedge has highlighted this fact, right?

P.S. This is a good example of what Barry Ritholtz called "intellectual jihadism" last week.

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Money Supply and the Recent Rally

I've been thinking about the market rally, GDP growth and money supply all morning. Here's my line of thought.

1.) Here's a P&F chart of the SPY rally. Notice it started on 7/31.



2.) The second quarter ended on 6/31. The BEA releases the GDP information on three dates: the last day of each subsequent month. So, we would have the 2nd quarter releases on the last day of July, August and September. In addition, the third quarter numbers would come out on the last day of October, November and December.

3.) By the end of November 2006 we had the second release of third quarter GDP. By then it was obvious the US economy was slowing down. Here is a chart of the last 4 quarters of the seasonally adjusted annual rate of US GDP growth.



4.) Here's a chart of the YOY change in money supply. Notice it starts to pick-up in roughly late October/early November. Let's assume the Federal Reserve policy makers have advance knowledge of the GDP numbers.



This train of thought leads to the following question.

1.) Is the Federal Reserve "priming the pump" -- keeping the market afloat with more actual dollars when the economy is slowing down?

2.) Why is the Federal Reserve Increasing money supply when they are concerned about inflation? Aren't they contributing to their problem?

Now -- why would the Fed do this?

1.) Increasing the money supply would help to ameliorate the slowdown by giving people more money to spend. This could partially explain why consumer spending has been robust throughout the slowdown -- people simply have more physical dollars in their pocket. This is an entirely legitimate exercise of the Fed's authority.

2.) The US has become an asset dependent economy. As the US savings rate has decreased, it's asset base has increased. And as those assets increase in value, people are more likely to spend. By the end of last year it was obvious one major asset class -- namely housing -- was decreasing in value. Therefore, the Federal Reserve has to stabilize the value of other asset classes -- here, equities.

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The Rise of Government Wealth Funds and Money Supply

From Barron's (subscription required)

Countries like China and Russia think they have sufficient reserves to meet potential runs on their currencies, and have created sovereign wealth funds in a bid to earn higher returns. Increasingly, these and other nations, including the oil-rich United Arab Emirates and Norway, are expected to funnel new money into wealth funds rather than government securities. Jen estimates sovereign wealth funds could match the size of official government reserves by 2

.....

Russia, which was nearly bankrupt a decade ago, is planning to put a chunk of its $357 billion of official reserves into a Future Generations Fund that will invest beyond government securities. That fund could be staked with about $30 billion. South Korea has formed the Korea Investment Corp. with $20 billion, and Australia has launched a $40 billion Australian Future Fund.

There are several reasons for the rapid growth of sovereign wealth funds. High oil prices are filling the coffers of countries like Russia, the Emirates, Saudi Arabia and Norway. Elsewhere, China's enormous trade surplus is producing rapid growth in its dollar reserves as the country seeks to hold down the value of the Chinese currency by purchasing dollars from Chinese exporters.

Here is a chart from the article that shows where some of these funds are:



There are several points that come to mind.

1.) Governments are assuming they have sufficient reserves to deal with a currency run. I'm not saying I know they don't. But because governments are looking at increasing wealth through investments, it's possible they are cutting corners to get these investments going.

2.) There's an amusingly socialist/communist angle to this situation. Governments are using capitalist financing to acquire business. So long as the governments remain on the sidelines I don't see any problems. However, if governments start to direct internal business decisions, we'll have the possibility of government run business.

3.) There's a ton of liquidity right now -- I mean a literal flood of currency.

Here's a chart of M2 from the St. Louis Federal Reserve:



Notice that starting in about 1995, the year-over year change in M2 was about 5%. Notice how there was a flood of liquidity during the recession. Also notice the recent increase in the year-over-year figures that corresponds to the latest stock market rally. Here's a chart of the last few years of growth to give you a better idea.



Here is a chart of M3 from the website Shadow Stats. I can't vouch for their methodology, but I present this graph because it's the only source I know of for M3 right now.



So, let's sum up.

1.) Governments are taking some of their excess currency reserves and building investment pools.

2.) Actual money growth is helping to create these pools.

3.) M3 growth -- if the Stadowstats numbers are accurate -- is really helping to build these funds.

This leads to the following questions.

1.) Is the Federal Reserve increasing money supply with the intention of spreading US dollars around the world?

2.) Is the Federal Reserve trying to quietly build these government investment pools with the intention these pools buoy US asset prices? This is especially important as the US economy has become more and more dependent on asset values.

3.) At a time when the Federal Reserve is concerned about inflation, why are they increasing money supply?

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