November 12, 2007
The pace of growth in money supply is a number that's meaningless in a vacuum. To quote a rate of expansion offers no more insight than looking a stock or bond and having no knowledge of valuations beyond. With that in mind, what can we say of the 6.6% advance (in nominal terms) over the past year in M2 money supply, based on the latest data for the week through October 29?
We can begin to search for an answer by considering the speed of the economy. For the third quarter, the government's current estimate tells us that nominal GDP grew by an annualized 4.7%. Using those figures in combination, it's clear that the Fed's printing money at a significantly higher rate than economic growth.
So, what have we learned? On its face, the data suggest that money supply is rising faster than prudence suggests. But again, additional context is necessary lest we make a hasty judgment.
Let's also add to the record that the 4.7% nominal GDP pace fell from 6.6% in Q2. For additional perspective, take note that the benchmark 10-year Treasury yield now stands at 4.23% and the Fed funds rate is 4.50%. In sum, interest rates are generally lower than the economy's rate of growth while money supply is rising at a pace that's substantially higher than GDP's growth.
All of which might be considered perfectly reasonably if the goal is to juice the economy and head off a slowdown. To be fair, a slowdown for Q4 and beyond is now on everyone's lips; only the degree seems to be in question. But once again, additional context casts a cloud of uncertainty over an otherwise obvious decision to err on the side of monetary stimulus.
Enter the humble dollar. Battered and bruised, the world's reserve currency continues to take it on the chin these days. The U.S. Dollar Index plumbs new lows virtually on a daily basis of late, and the greenback against the euro looks even worse.
Everyone knows that capital prefers to reside in currencies where interest rates are higher rather than lower, thus the enduring possibilities of the so-called carry trade. The Fed seems inclined to dismiss such inclinations for the moment in favor of hedging against the possibility of recession. That may be wise, it may not be, depending on what happens. In particular, the question is whether a continued rout in the dollar feeds on itself and triggers economic and financial repercussions that are unexpected. No one expects the Spanish Inquisition, as the old Monty Python bit went. But that doesn't mitigate the pain if and when it arrives.
Such is a central banker's task in life: picking a poison and hoping for the best. But with soaring commodity prices one might wonder if the threat of recession is only part of the hazards stalking macro strategy.
"We continue to believe the greatest risk lies with the Federal Reserve orchestrating easier monetary policy to address the excesses in the financial sectors of the economy," Edward Jong, a portfolio manager with FrontierAlt All Terrain Bond fund in Canada, told The Globe and Mail in story dated today.
The challenge is compounded by the growing pressure on the Fed for yet another rate cut. "The market is almost forcing the Fed's hand [to cut rates]," Robert Marcus, another portfolio manager at FrontierAlt All Terrain Bond said in the G&M article. "But it's not a slam dunk," he added.
Indeed, the current story has no obvious ending yet. Various outcomes are still possible. The Fed could print too much money and exacerbate inflation, or perhaps it'll add just the right amount of liquidity to keep the economy bubbling without overdoing it. Meanwhile, the dollar seems due for a technical rebound, and oil prices have probably run too high too fast, at least for the short term. Perhaps there's a bit of respite coming, offering strategic-minded investors and central bankers alike a chance to catch their breath and reassess.
Maybe, maybe not. We don't know and neither does any one else. We can guess, of course. Meantime, we'll be watching the numbers. No doubt one asset class or another will fall prey to some excess or another. In fact, there are already some encouraging signs, albeit early signs that value is creeping back into some corners of the capital markets. Nothing dramatic, but at this stage of the game the mere sight of valuation trends moving in favor of buyers is a rare bird after the virtually non-stop bull markets of the past five years that have delivered the opposite.
For now, we're watching and waiting, eager to redeploy our overweight of cash. But not quite yet, at least nothing of consequence. A nibble here and there. Stay tuned for details....
Posted by jp at November 12, 2007 9:35 AM
Demand and supply and inextricably linked. The Fed doesn't directly control demand for money, but demand in a macro sense is greatly influenced by supply over time. In short, the Fed has enormous control over M2, which is how it controls the price of money and influences demand. The evidence is that the price of the various M2 components are heavily influenced by the Fed funds rate. There's a reason why yields on money market funds, 3-mo Tbills, CDs, etc. have a very high correlation with the Fed funds rate.
The bottom line is that if the Fed wants M2 to rise or fall over time, that's within its powers, thus the chart of 52-week rolling percent changes. The Fed has several options for "printing money," which is a widely recognized euphemism for the central bank's capacity for managing monetary policy.
Any investor is, of course, free to ignore Fed actions and decide to buy a CD or money market fund independently. But in the aggregate, investors' demand for short-term securities is heavily influenced by the central bank.
Finally, I'll quote from Anna Schwartz, the respected economist on these issues, courtesy of The Library of Economics:
"Federal Reserve policy is the most important determinant of the money supply. The Federal Reserve affects the money supply by affecting its most important component, bank deposits.
Here's how it works. The Federal Reserve requires commercial banks and other financial institutions to hold as reserves a fraction of the deposits they accept. Banks hold these reserves either as cash in their vaults or as deposits at Federal Reserve banks. In turn, the Federal Reserve controls reserves by lending money to banks and changing the "Federal Reserve discount rate" on these loans and by "open-market operations." The Federal Reserve uses open-market operations to either increase or decrease reserves. To increase reserves, the Federal Reserve buys U.S. Treasury securities by writing a check drawn on itself. The seller of the Treasury security deposits the check in a bank, increasing the seller's deposit. The bank, in turn, deposits the Federal Reserve check at its district Federal Reserve bank, thus increasing its reserves. The opposite sequence occurs when the Federal Reserve sells Treasury securities: the purchaser's deposits fall and, in turn, the bank's reserves fall.
If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, however, can create a multiple expansion of deposits. As each bank lends and creates a deposit, it loses reserves to other banks, which use them to increase their loans and, thus, create new deposits, until all excess reserves are used up."
Posted by: JP at November 13, 2007 10:35 AM
M2, M3 and MZM are not functions of Fed policy. You wrote that "...its clear that the Fed is printing money..." That is patently false. The adjusted monetary base or reserve bank credit are the measures of money that are controlled by the Fed. The other 'Ms" are measures of money "demand" not money supply. Selling a stock and buying a CD for example reflects my demand for money not the Fed printing money. A pretty easy concept but so consistently misunderstood.
Posted by: BGC at November 12, 2007 10:29 PM
Well, not quite. The Fed controls the supply of M2 money supply by various monetary tools at its disposal, including its open market operations for managing short-term repurchase and reverse repurchase agreements.
Further, to quote Ben Bernanke from a few years back, "the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
The bottom line: all of the components in M2 (M1 + various short-term money market instruments and equivalents) are directly or indirectly influenced by Fed actions. Why? Because the central bank controls the price of short-term dollar-denominated instruments. Long-term rates are another matter. The price of short-term instruments, however, are inversely related to supply. If the Fed wants the price to rise (fall), it contracts (raises) the supply.
Posted by: JP at November 12, 2007 7:56 PM
How does the Fed directly control the pace of M2? M0, sure. M1, maybe. But M2 is dependent on how people choose to allocate their investments between savings accounts, time deposits, and all the other investment opportunities out there...
Posted by: A at November 12, 2007 11:00 AM