On the demand for money and other considerations

This blog has consistently employed a supply-side approach to fiscal policy (e.g., improving the incentives to work and take risk tends to lead to a stronger and more prosperous economy, as does reducing regulatory burdens) and a classic approach to monetary policy (e.g., inflation occurs when the supply of money exceeds the demand for it). In this post I focus on monetary policy, reiterating and amplifying observations that I have made over the past decade or so.

It's easy to measure the supply of money, and the Fed provides those statistics weekly. The M2 measure of money is broadly favored, and it is the one I have consistently used. More recently I have emphasized two components of M2—savings deposits and demand deposits—which together comprise about 75% of the $18.4 trillion M2. I have argued that these two measures are a good proxy for the demand for money, even as they are also measures of the supply of money. Both components represent money that has been set aside my consumers and businesses as a form of saving, security and/or comfort—essentially a hedge against risk. They are distinct from checking accounts and currency in circulation, since those are held primarily for convenience (e.g., to make monthly payments and to make miscellaneous purchases) rather as a risk-free store of money.

With the interest paid on savings deposits and demand deposits now hovering just above zero, it's easy to see why these deposits are a good proxy for money demand. Since they yield practically nothing, people hold them simply because they want a store of value that is easily accessible and relatively risk-free. For most of our history, these deposits paid an attractive rate of interest that was greater than the prevailing rate of inflation (i.e., real interest rates were positive). Those conditions (high interest rates) served to muddy the monetary waters, since it's tough to know whether people held these deposits as investments or merely as a store of value. Now, with interest rates at or near zero it's easy: they respond directly to people's demand for money and safety.

As I predicted back in 2009 and 2010, when the M2 measure of money was growing faster than ever before, the then-rapid growth of money would not be inflationary, because rapid M2 growth was being driven by strong growth of savings and demand deposits. The Fed was accommodating a huge increase in the demand for money; the Fed was NOT "printing money" with abandon as so many thought. (That includes yours truly, since I worried about rising inflation in late 2008 and early 2009. I later realized I was wrong.) The proof of the monetary pudding, as it were, was to be found in the fact that inflation has been low and relatively stable for a long time. Indeed, the world has worried more about deflation in the past decade than it has about rising inflation, despite rapid growth in the money supply.

How do you get low and even falling inflation when the supply of money is expanding rapidly, as it did in late 2008 and early 2009? It can only happen if the demand for money is growing as fast or faster than the supply of money. If a farmer is selling more apples every day it's because the demand for apples is also increasing every day; otherwise he would find himself with a glut of apples and would soon have to cut the price of his apples. A lower price would be required to bring demand back into line with supply.

What follows are some charts which focus on money supply and money demand. The story they are telling is similar to what it was a decade ago: incredibly rapid money growth is occurring because the demand for money is incredibly strong. The Fed is not printing money and so, for the time being at least, there is little risk of inflation.

Chart #1

Chart #1 shows the composition of the M2 measure of the money supply. Bank savings deposits make up by far the biggest portion, and they currently total almost $11.6 trillion. Currency is the next largest portion, currently totaling $1.9 trillion. One could argue that currency in circulation in a good measure of money demand, because nobody holds onto currency unless it serves them a purpose. It's complicated, however, because foreigners hold the vast majority of US currency. Do some math, and you will see that if $1.9 trillion of currency (mostly $100 bills) were held by only US residents, then each of us would be holding almost $6,000 in cash on average. Don't know about you, but my family rarely has more than $1000 in cash lying around or stashed under the mattress. Currency tells us a lot more about foreigners' demand for money than it does about the demand for money of US residents. Interestingly, currency has surged at a 23% annual rate since last February, which suggests the whole world is scared of Covid—which is not surprising since Covid is a problem everywhere. In any event, the Fed supplies currency only on demand, and in exchange for bank reserves, so the supply of currency and the demand for it are always in balance.

Chart #2

Chart #2 shows the level of the M2 money supply compared to the long-term trend rate of M2 growth (green), which has averaged about 6.5% per year for the past 20 years. M2 exploded starting last March, as the Fed pulled out all the stops and the federal government began mailing big checks to tens of millions of displaced workers and struggling businesses. M2 has now increased by about $3.2 trillion over the past seven months. Growth in savings and demand deposits account for about 80% of the increase in M2.

Here's the underlying and underreported story: federal debt has increased by almost the same amount ($3.4 trillion) as M2 has since last March. The Fed bought substantially all of the Covid-era federal debt (notes and bonds) issued by the federal government and paid for them with bank reserves. The banking system experienced an equivalent surge in deposits, which they used to buy the treasuries the Fed then bought from them. The banking system effectively "invested" their deposit surge in bank reserves. By buying over $3 trillion of treasuries, the Fed effectively converted (transmogrified, as I like to say) notes and bonds into short-term, risk free assets, since bank reserves are essentially T-bill substitutes which the banks find to be an attractive way to invest their deposit inflows. Bottom line, the increase in the money supply was driven by an equivalent increase in the demand for money and money equivalents. That's not inflationary. 

Chart #3

Chart #3 shows the 3-mo. annualized growth rate of savings and demand deposits, which was truly explosive from early March until just a few months ago. Note how this component of M2 also experienced rapid growth around the time of the Eurozone crisis in 2011, when money fled to the security offered by US banks. Note also how the growth of savings and demand deposits slowed in the wake of the Nov. '16 elections: money held in safe form flowed back into the economy as confidence increased and the economy prospered. If we're fortunate, the economy will sooner or later lose its fear of Covid and money will once again leave deposit accounts and go back into the economy, there to fuel rising consumption and an expanding economy.

It's important to note here that the growth rate of M2 has almost completely returned to what it was prior to the Covid crisis: in the past three months M2 has increased at about a 10% annualized rate, and in the three months prior to last March, M2 increased at about a 6% annualized rate. What that means is that demand for money is no longer rising by much. Thus the Fed has little reason and little need to continue to convert notes and bonds into T-bill equivalents. Simply put, there doesn't seem to be a need for much more "monetary stimulus" as it is incorrectly referred to (actually, it's just an accommodation of increased money demand).

Chart #4

Chart #4 compares the level of nominal GDP to the level of M2. Both have increased by about the same order of magnitude over the past 60 years. Until this year, that is. What's happening is that the economy has effectively and suddenly increased its desire to hold money rather than to spend it. This is a natural reaction to the great uncertainty and fear that the Covid crisis has caused. But as that tendency reverses—as the demand for money declines—there is plenty enough money out there to fuel a big increase in real and nominal GDP.

Chart #5

Chart #5 divides the level of M2 by the level of nominal GDP. I've labeled the result "money demand." I like to think of this as being a proxy for the amount of cash and cash equivalents the public wants to hold, expressed as a percentage of average annual income. Prior to the Covid crisis, as a country we were comfortable holding a cash and cash-equivalent reserve equal to about 70% of our annual income; now it's almost 90%. Money demand was relative stable for many decades, but it has increased dramatically in the wake of the Great Recession and now during the Covid panic. However, money demand is already beginning to decline. I've estimated the value of the ratio for the third quarter, assuming 10% annualized growth in M2 and a 30% annualized growth of nominal GDP. It will probably decline a lot more in the months and the years to come as confidence returns and the economy grows.

What happens when the demand for bank deposits declines? Let's say the public decides over the next year to withdraw $1 trillion of the $3 trillion they added to bank deposits this year. As the money is withdrawn, banks will no longer need $1 trillion of the bank reserves they "bought" this year. Banks can simply sell their reserves back to the Fed in exchange for notes and bonds. They can then sell the notes and bonds in exchange for cash which they can then distribute to those who are withdrawing their money. In the process, the demand for notes and bonds will decline, and that would likely translate into higher interest rates. Which is exactly what we would expect to happen as the economy recovers and returns to more normal conditions. If the Fed is on top of this development, they will happily sell notes and bonds and retire bank reserves, and the money supply will shrink in line with a reduction in money demand. But if the Fed insists on keeping plenty of reserves in the banking system, they would risk creating a surplus of money and that would be inflationary.

One soon reaches the conclusion that the Fed has been reacting to changes in the demand for money rather than stimulating anything. I and others have said this many times in the past. The Fed would have us believe they re setting the tone and the level of interest, when in reality they are simply accommodating the mood of the market. Whatever the case, it is clear that interest rates are extremely low not because the Fed has said so, but because the market's demand for short-term, cash-equivalent assets (e.g., T-bills and bank reserves) is enormous. The market is willing to pay such a high price for them that their yield has been pushed down to near zero. Thus, the prevalence of near-zero or even negative interest rates can mean only one thing: risk aversion remains very strong these days. The market is not exuberant or irrational. The Fed has not stimulated anything.

Chart #6

Chart #6 is my favorite way of seeing whether the Fed is behaving correctly. The blue line is the inflation-adjusted Fed funds rate (i.e., the Fed's target rate minus the year over year change in the Core Personal Consumption Deflator), and the red line is the real yield on 5-yr TIPS, which in turn is essentially the market's expectation of what the real funds rate will average over the next 5 years. When the blue line is below the red line, the Fed is behaving well and the economy is healthy, because the market is expecting the real funds rate to rise in the future. But when the blue line is above the red line this means the Fed is so "tight" that the economy is likely to weaken and the Fed will eventually need to lower the real funds rate in response. Today it looks like the Fed is just about right. 

The charts that follow are interesting in their own right, and help me to understand what's going on in the economy:

Chart #7

Chart #7 compares the price of gold to the price of 5-yr TIPS (using the inverse of their real yield as a proxy for their price). It's remarkable that the prices of these two completely different assets should be so closely correlated over so many years. I can only conclude that the market views both assets as "safe havens." Both provide insurance against nasty events: gold protects you from disasters of all sorts, and TIPS are guaranteed to protect you against a rise in inflation. Both prices appear to have peaked, which suggests that the demand for money and safety has peaked. That confirms the message of M2.

Chart #8

Initial claims for unemployment were disappointingly unchanged last week, but continuing claims continued their strong downtrend, as seen in Chart #8. From a peak of 25 million in early May, they are now down to 11 million. That means that at least 14 million people who lost their jobs have now gone back to work. In other words, 60% of the jobs lost have been recovered, which further suggests an ongoing decline in the rate of unemployment. That counts as a V-shaped recovery in may book. It's tragic, however, that there are still so many unemployed, and that their ranks are filled with the most vulnerable. The only solution for so much misery is to OPEN THE ECONOMY ASAP. Failing that, the government should somehow compensate the workers who have fallen on hard times directly as a result of terribly misguided public policy choices. 

Chart #9

Car sales, shown in Chart #9, have almost completely reversed their Covid plunge. Another V-shaped recovery.

Chart #10

CDS spreads, shown in Chart #10, are the most liquid measure of generic corporate credit risk. Happily, they are very low, as are swap spreads. This strongly suggests that liquidity conditions in the financial market are very healthy and the outlook for the economy is also very healthy. 

Chart #11

Chart #12

Charts #11 and #12 show that air travel is decidedly NOT enjoying a V-shaped recovery. For the past three months, gains in passenger traffic have been very small. Overall traffic today is still down some 66% versus year-ago levels. A sobering statistic. Fear of flying will be with us for a long time, it would appear.

Covid comments

Catching Covid is not a death sentence, as Trump has showed us: "Don't be afraid of Covid. Don't let it dominate your life." Very wise words from our Commander in Chief, who is unafraid to bow to the prevailing orthodoxy of fear. In that regard, Heather Mac Donald has a very good quote (HT Mark Perry):

"Reopening is still the right policy. Mandatory outdoor mask-wearing is merely a way for government to turn citizens into walking billboards of fear, sending the false message that danger is everywhere. Infection rarely leads to death. Most of the infected recover. Given his governmental duties, the surprise is that Trump—as president, another kind of front-line worker—has not gotten sick before now."

Don't miss the Great Barrington Declaration, an open letter signed by more than 7,000 mental & public health scientists and medical practitioners. In it they argue strongly for opening the economy, especially schools, while protecting the vulnerable (i.e., mostly the elderly and infirm). Here is a functioning link for the Great Barrington Declaration.

UPDATE: A MUST WATCH VIDEO by Dr Reiner Fullmich. An intelligent, well-argued brief for why there was never a Covid “pandemic.” It’s always been just a bad flu, as I and many others have been arguing since last April. Lockdowns have had no impact. Tests, as even the NY Times has admitted, cannot reliably detect Covid infections, and the vast majority of positive results are false positives. It’s a “case-demic” not a pandemic. Governments everywhere have systematically trampled the constitutional rights and liberties of their people without any justification. Watch it and weep for the miseries unnecessarily inflicted upon millions of innocent people and businesses.