February 19, 2007
MONEY QUESTIONS (AGAIN)
Bull markets can be found everywhere, and the M2 money supply is no exception.
Measured on a rolling 52-week basis, seasonally adjusted M2 rose by 5.6% for the year through February 5, according to Federal Reserve data. That's the fastest annual pace in two years, as our chart below shows.
How fast is 5.6%? For perspective, the economy expanded at a 5.0% annual rate during last year's fourth quarter (measured in seasonally adjusted nominal terms, as per the Bureau of Economic Analysis). The point, dear readers, is that money supply is expanding at a rate faster than the economy's.
This isn't a problem, at least not yet. But depending on where we go from here, it may be a warning sign. As a recent Cleveland Fed piece reminded, inflation is a monetary phenomenon. Milton Friedman famously made that observation, and the Cleveland Fed essay offers some supporting numbers. The article cites a 0.85 correlation (1.0 is perfect positive correlation) of inflation with average M2 growth for 132 countries for the 40 years through 2000, concluding "that prices move almost proportionally with the stock of money."
From our perch, that looks fairly definitive. Nonetheless, worries about inflation are less than common these days. The benchmark 10-year Treasury Note's yield is engaged in yet another run south, closing 4.7% on Friday for the first time since January 10. Meanwhile, the implied inflation rate for the next decade, drawn from the spread between the 10-year nominal and 10-year TIPS, is a modest 2.34%, or slightly below last year's 2.5% rise in consumer prices. What's more, the futures market expects no change in Fed funds any time soon. If and when the central bank changes Fed funds, the next adjustment is likely to be a cut in the price of money, or so futures contracts maturing late this year predict.
In sum, the crowd believes that inflation's dead and buried. As a result, the Fed appears to have a free hand to elevate the rate of growth in M2 without fear of retribution from the bond market. All of which raises questions: How long will the Fed raise M2 above the rate of economic growth? Does it matter? Does any one care? Is Milton Friedman's observation about money supply and inflation no longer relevant?
To some extent, the answer depends on who's talking. For what it's worth, when the gold market chatters these days, it speaks of anxiety about the future. Consider, for instance, streetTRACKS Gold Shares (GLD), a gold-linked ETF that's been climbing this year and is now trading at its highest since last spring.
Posted by jp at February 19, 2007 9:12 AM
You mention that the money supply is expanding faster than the economy. But, this isn't the first time nor has there been some of the problems during those times when that you mention. Take for instance M3 from 1993 to 2001. There was a firming growth rate in the money supply during the entire 8 years. Yet, it wasn't until the very end that we saw a recession.
Perhaps it's premature to be stating that we're going to have problems when looking at the situation from a larger time perspective.
Posted by: David Andrew Taylor at February 20, 2007 11:00 AM
Looking at the now-discontinued MS broad money supply chart, found on several tracking websites, it's 10% growth. I think the Fed's lost control of the money supply, first by not reigning in banks by increasing bank reserve requirements, and second by not increasing sharply the mortgage lending requirements. Bernanke was questioned repeatedly about this latter in his House testimony, and gave a wispy answer that OCC and others were still involved in "discussions" about raising mortgage qualifications. Maybe "lost" is not the right word, but rather "handed over."
Posted by: OldVet at February 19, 2007 10:16 AM