Tuesday, January 17, 2012

Money demand is the key monetary variable

The most remarkable development on the monetary front in recent years has been the unprecedented surge in money demand, as shown in this chart. (I'm measuring money demand as the ratio of M2 to nominal GDP.) Think of money demand as the ratio of your liquid, cash, readily spendable assets (M2) to your income (GDP). From the end of 2007 to the end of 2011, money demand surged by 21%: that is, the M2 money supply increased 21% more than nominal GDP.

Virtually all of the increased demand for money occurred in the savings deposit category (the largest component of M2), which increased by just over $2 trillion from Dec. '07 through Dec. '11. In general terms, and roughly speaking, households and firms increased their savings deposits relative to their incomes by $2 trillion over the past four years. It's not hard to understand why, either. The flight to cash and safety was driven by the recession that developed over the course 2008, the collapse of U.S. housing prices, and the near-collapse of the global financial system in late 2008. Then we had the Eurozone sovereign debt default scare which began last year and which threatened to create another global financial panic and economic collapse. In short, firms and households have been hit with one panic after another, and not surprisingly have become extremely risk-averse in the process. Nearly everyone has been setting aside cash and building up savings deposits for a rainy day.

The huge increase in money demand doesn't show up as an extraordinary increase in M2, however, as the two charts above suggest. M2 is growing a bit more than its long-term average (6% per year), and that outsized growth can be easily traced to the financial panic of 2008-2009 and the PIIGS default panic that hit last year. But the extra M2 growth has come at a time when nominal GDP has experienced a significant deceleration, which is why the ratio of M2 to GDP has increased so dramatically.

The Fed has had to accommodate this huge increase in risk aversion and money demand by hugely expanding bank reserves. Bank reserves have increased almost $1.5 trillion since the Lehman crisis hit, and most of those reserves sit on the Fed's balance sheet as excess reserves, parked there by banks that are also very risk averse and unwilling to make the massive loans that those reserves would ordinarily allow. If the Fed had not taken extraordinary action to expand the monetary base by $1.8 trillion ($1.5 trillion of new bank reserves plus $250 billion of new currency), today we would probably still be engulfed in the global depression and deflation that so many were expecting at the end of 2008.

What this all means is that there is approximately $2 trillion that has been set aside by households and firms for a rainy day. It's a massive dam of liquidity that has been held back by fear. Should that rainy day fail to materialize (e.g., should Eurozone defaults fail to plunge the global economy into a depression, and should the U.S. economy continue to slowly improve), then there is the potential for a $2 trillion flood of liquidity to released. It's not likely to happen overnight, but over the next several years we could see that liquidity being gradually shifted into more equity exposure, more consumption, and higher prices in general. And the key to that gigantic potential shift is money demand, which has been driven by fear. If and when fear fades and confidence in the future returns, there is huge potential for changes on a number of fronts.

More importantly, I believe this process is already getting underway, as shown in a variety of indicators: a significant pickup in Commercial & Industrial Loans (increased borrowing is the flip side of reduced demand for money), today's big increase in the Empire State Manufacturing Index, the 6.5% increase in retail sales over the past year, the reversal of euro basis swaps, the decline in weekly claims, the pickup in hiring, the decline in the Vix Index, the 24% increase in housing starts in the past 12 months, and the big increase in the Citi Economic Surprise Index, to name just a few.


Benjamin Cole said...

Yet another very solid post by Scott Grannis.

However, I would recommend reading

http://www.centerforfinancialstability.org/amfm_data.phpd reading

It appears the Fed is actually passively constricting the money supply, at least by certain measures--or so these guys say.

Using my divining rod, I detect the Fed is tightening the money supply, relative to need, as I see declining property values and rents, equities are down, and unit labor costs down. Japanitis.

After we get strong, multi-year rallies in stocks and real estate, I might be convinced otherwise. But not now.

Public Library said...

If you are a liberterian then it's impossible to beleive the Fed is doing the right thing. Creating zombie corps feasting off .25% funds rates is no way to build the real economy. Sorry.

There is no need for fiat money to increase at even 6% per year. If someone has documentation, please share it with the world.

William said...

Scott wrote: "What this all means is that there is approximately $2 trillion that has been set aside by households and firms for a rainy day."

Does this figure include mutual fund money market accounts? I have read that individuals have $2 or 3 Trillion parked in Money Market Accounts. I have also read that corporations have $1 Trillion plus liquid assets on their strong balance sheets.

I would have thought that the total figure was $3 or 4 Trillion parked in liquid accounts.

Squire said...

How satisfying to understand this.

From my memory, M2 is checking and savings accounts and CDs under $100,000. It is inventoried cash.

Scott Grannis said...

William: Retail Money Market Funds only total about $700 billion. Corporations do have at least a trillion in cash on their balance sheets, but a good portion of that is held overseas, and in any event, the vast bulk of the "cash" that is held by corporations does not show up in M2. So if you add back in things that are "almost like M2 cash," then you could reasonably come up with a store of liquidity that approaches $3-4 trillion. My analysis is quite conservative, as it should be.

Scott Grannis said...

Squire: here is the approximate current composition of M2:

Checking accounts $1.2 trillion
Currency: $1 trillion
Retail Money Market Funds: $700 billion
Small Time Deposits (CDs): $760 billion
Savings Deposits: $6 trillion

Bill said...

The recovery in confidence and the economy generally will begin in November.

Hans said...

A most informative thread.