Monday, December 19, 2011

M2 update

The first chart shows the history of M2—arguably the best and broadest measure of "spendable" money—over the past 17 years. As should be obvious, there is no shortage of money; M2 has been growing by more than 6% a year for a very long time. The second chart narrows the focus to the past 5 years. On this scale, two "bulges" in M2 growth stand out, and they correlate nicely with periods of financial panic which caused the public's desire to hold "money" to rise. The late 2008 bulge gradually disappeared as the recession ended and the confidence returned. The current bulge also looks to be gradually fading, which could be a welcome sign that fear of a Eurozone financial collapse is beginning to abate.

Almost all (80%) of the latest "bulge" in M2 has come in savings deposits at large commercial banks, and this category is by far the largest component of M2 (see above chart). The Fed cannot force-feed money into savings deposits; people park money in banks only because they want to hold it, and that is especially true now that the interest rate on savings deposits is virtually nil. In other words, exceptional M2 growth in recent years has been almost exclusively a demand phenomenon, rather than a supply phenomenon: it's not that the Fed is running the printing presses in order to push prices up, it's that the demand for money has surged to unprecedented levels, and the Fed has been willing to accommodate this with generous supplies of bank reserves. Exceptional M2 growth has not sparked a big rise in inflation, because it has been the result of increased money demand. This may well change in the future, of course. If the demand for money begins to decline and the Fed does not act in a timely fashion to withdraw bank reserves from the system, then we could have an inflationary problem. This is one of the fears the weighs heavily on markets, and is likely one of the reasons that the price of gold has doubled since 2008.

This chart tracks money demand (the ratio of M2 to GDP). Since the onset of the 2008 recession and subsequent financial panic, the public's demand for money balances has soared in unprecedented fashion, and to an all-time high. The M2/GDP ratio has increased almost 20% since the end of 2007; i.e., money growth has exceeded nominal GDP growth by 20% in the past four years. If the increased demand for M2 in recent years were to reverse without there being an offsetting decline in the amount of M2, this could eventually fuel an extra 20% increase in nominal GDP, and much of that could come in the form of higher inflation.

In fact, money demand has most likely already fallen from its peak, because annualized M2 growth in the most recent 3-mo. period has been only 2.6%, while nominal Q4/11 GDP growth is likely to be at least 5% (e.g., real growth of 3-4% and inflation of 1-2%). If the Eurozone crisis manages to morph into a non-catastrophic problem, then confidence will slowly return, money will come out of hiding and be spent (e.g., be withdrawn from savings deposits), and economic activity will almost certainly pick up. We could be in the very early stages of this process already.


Benjamin Cole said...

Now is not the time to worry about inflation. It is the time--indeed it should always be the time---to worry about growth.

Money is just a nominal index, a system for counting value. There are some good results from moderate inflation, and I am always surprised that it is an article of faith in some quarters that inflation is necessarily bad.

That is, if you can even measure inflation in a world of rapidly changing goods and services.

I can take 100s of photos and e-mail them to Thailand instantly. For nearly zero marginal cost. Explain inflation to me again. Or explain when I get medical treatment that saves my life, when such treatment did not exist 10 years ago. Inflation?

The USA of the 2010s is not the USA of the 1970s. The labor force has de-unionized, and global trade and supply chains have augmented domestic. The supply side is incredibly vaster than before, aided by the web. Sheesh, even unheralded Craigslist has opened up entire markets.

Try raising your prices today---unions can't do it, retailers can't do it, only federal civilian and military agencies and attached grifters appear to be able to do it.

The ancient battle cries against inflation are misplaced today.

The goal going forward must be growth and mild inflation---the risk is not Weimar Republic, but Japan.

McKibbinUSA said...

Main Street USA remains mired in economic depression, despite the apparent growth of the M2 money supply...

Ed R said...

Suggest that this stronger growth of M2 (and other forms of liquidity) in a time of stagnant GDP is more evidence of a liquidity trap --as if we hadn't seen enough already.

Ed R said...

Is a semi-log vertical axis appropriate when already measuring by percentages??

Just askin' - - - - Where are the statisticians??

William said...

Scott - I am most impressed with your estimate of nominal 4th Quarter 2011 GDP growth of "at least 5% (real growth of 3-4% and inflation of 1-2%)". That would certainly dispel concern for a "double dip recession" and will be good for equities!

Here's hoping.