Friday, July 17, 2009

Monetary green shoot -- currency has stopped growing

This chart illustrates what could be a very important and bullish development for the economy: the coming decline of money demand.

Background: Dollars in circulation (most of which are held overseas) surged beginning in mid-September of last year, as fears of a financial market collapse caused people all over the world to stuff money under their mattresses (figuratively speaking, of course, but I do know a person in Argentina who sold all of his portfolio holdings last year, converted everything to $100 dollar bills, and then hid them in his house). The demand for dollar cash and dollars in general (as a safe haven and to pay down debt) was so intense that the Fed had to resort to a massive expansion of the monetary base to avoid a sudden onset of deflation. This surge in the demand for dollars also meant that instead of spending money, people simply held onto it and at the same time wanted more of it. Economists call this a plunge in money velocity, and it resulted in a sudden and massive decline in retail sales. That in turn caused a huge rise in inventories, and manufacturers were then forced to respond by slashing production.

With the benefit of hindsight, it now looks as if the fear of collapse started to decline last March. People began to decide they didn't need to accumulate more dollar cash. On the margin, the demand for dollars stopped rising. Which is another way of saying that the velocity of money stopped falling. Currency in circulation has been flat since mid-April, but there are still lots of dollars sitting under mattresses.

The next shoe to fall is the key. Dollar demand will likely start falling, and money velocity will likely start rising. All the extra money that was stuffed under mattresses will either get returned to the bank, or it will get spent. Consumer demand will return, powered by precautionary holdings of money that are no longer needed.

It's not unreasonable at all to expect this to happen. Indeed, the demand for dollars in the world currency market has been falling since mid-March; the dollar is down over 10% against major currencies. The next chart shows a very strong correlation between the equity market and the changing demand for dollars (a weaker dollar goes hand in hand with a stronger equity market, and vice-versa). Declining dollar demand today means that precautionary balances are likely to be spent, and that is lifting the economy and brightening the prospects for the future.

1 comment:

Donny Baseball said...

I'm wondering what alstry thinks...!!