Friday, February 20, 2009

Money Supply, in Vogue Again?

Along with shaggy hair on boys and hand-wringing about inflation, money supply -- that favorite 1970s indicator of economic cycles -- is making a comeback.

Some economic forecasters and strategists are pointing to a steep five-month rise in the amount of money held as indicating that a recovery in the U.S. economy is slowly but surely getting under way.

The rise in the M2 measurement of money supply is saying "monetary policy is pretty easy and the economy may pick up before the consensus expects it," said Paul Kasriel, chief economist for the Northern Trust.

Kasriel, for years one of the gloomier private-sector prognosticators thanks to his early forecast that the U.S. housing market was on the path to meltdown, now has a sunnier outlook. He expects the economy to start recovering by the fourth quarter and that it will avoid a prolonged, debilitating bout of deflation.

One reason, he says, is the federal government's spending to get out of the financial crisis, which is forcing more money into the banking system. The Fed has injected roughly $1 trillion into credit markets in the past year by buying commercial paper and agency bonds, for instance. And the Treasury is issuing record amounts of debt to underwrite the federal deficit. If the Fed buys back more of that debt, its puts more money into supply.

Forecasters like Kasriel say some of the government's actions are already showing up in bank accounts.

The M2 measure of money, which includes currency in circulation, checking accounts, saving accounts, and balances in retail money-market funds, has jumped sharply since September.

In January, the M2's annualized growth rate over the previous three months jumped to nearly 18%. In August, the three-month average growth rate was less than 3%.

These higher savings, in turn, should spur more bank lending and thus economic recovery.

"It's not as good as it used to be but it's still better than a lot of things," said Kasriel of M2's track record as a predictor. "It does a pretty good job of foreshadowing what the economy is going to do."

Growth in the money supply was the main contributor to the second straight monthly rise in the index of leading economic indicators, which tries to forecast economic activity six to nine months in the future, the Conference Board said Thursday.

"Because M1 and M2 are growing, there will be an economic recovery," said Craig Callahan, a $2.5 billion value fund manager. M1 refers to a narrower measurement of money.

He has been telling clients that the increase in the past half year -- after three and a half years of modest growth -- means "this economic recession has a finite life."

Usually, Callahan says, it takes six to nine months for a pickup in money supply to take effect. That would mean a turnaround is already under way.

The "combination of money supply growing plus the fiscal stimulus means we would expect the market to move sharply higher in the coming months," he said.


Following the money supply down to the fifth decimal place was a popular activity for economic forecasters from the 1960s to the mid-1980s, when the actions of the Federal Reserve to pump more money into circulation often foreshadowed a turn in the economic cycle.

Central banks such as the Federal Reserve also set targets for money supply to achieve its goals of keeping the economy growing and prices stable.

Those who believe in using the money supply as a leading indicator point to recoveries such as the one following the recessions in 1973-1975 and the early 1980s as evidence money supply can successfully determine future growth.

For example, by December 1981, the annualized three-month average rate of M2 growth had risen to more than 12%, up from less than 6% in July 1981, the start of the 1981-1982 recession. By the end of 1982, the economy started an expansion that would last more than seven years.

Measures of money supply have fallen out of favor with private-sector forecasters as well as the Federal Reserve in the past 20 years, however. Over that time period, savers put more of their money into increasingly popular non-bank investments, such as cash-like bonds and stock mutual funds.

In recent years, the Federal Reserve has also debunked the merits of using the money supply to predict economic growth. In 2006, it stopped publishing a third measure of money supply, the M3, because it decided it was not worth the resources to collect that set of data.

But the flood of Fed cash into the credit system in this cycle -- and the ensuing worry that this liquidity spigot will lead to runaway inflation -- has prompted senior Fed officials recently to spend more time talking about the impact of money-supply growth.

The higher-than-normal increase in M2 is primarily due to investors' demand for greater safety, Fed Chairman Ben Bernanke wrote in the footnotes of a speech he gave Wednesday. "We expect growth in M2 to slow considerably in 2009," he wrote. The Fed, he said, sees "little risk of unacceptably high inflation in the near term."

But even the naysayers acknowledge the indicator is making somewhat of a comeback.

"It's made a bit of a revival now," said Nomura's Pandl. "We're in a period of unconventional monetary policy. People are looking at different metrics, and money supply has made a resurgence."


1 comment:

SteveMDFP said...

Debt is a form of money that isn't included in M0, M1, M2, or M3. For a thorough discussion of debt-as- money, see:

The money supply isn’t expanding, it’s collapsing.

Few will agree with that, because M0, M1, M2 are all moving upwards. But none of these include newer debt instruments.

Debt is traded and transferred like other forms of money. Over 60 TRILLION dollars of credit default swaps (CDS) alone existed at their peak. The value of this form of money is plummetting, and this represents a rapid collapse of the effective money supply that is an order of magnitude greater in the downward direction than the upwards movement of M2 and other measures.

The Federal Reserve is expanding the more traditional measures of money supply to compensate for the collapse of the total real money supply. The seemingly-reckless expansion of M2 is a result of attempting to compensate for the far-larger collapse of the real money supply.

Thus, the “asset deflation” is really no different from price deflation and reflects the contraction of the money supply. Welcome to 1929, relived.

What the Federal Reserve is doing (quantitative easing) is absolutely correct, but probably still too small to achieve the needed effect.

The fiscal stimulus of big federal budget deficits is also perfectly appropriate, but probably too small to achieve the needed effect.