For the first time since late-2010, the monetary base in the U.S. has been contracting on a year-over-year basis as of this past June. Does that represent a significant change for assessing risk in the outlook for the business cycle? Possibly… if the contraction rolls on.
A proper analysis of the business cycle requires the monitoring of several factors, of course, but there’s a strong case for putting the monetary base—“high-powered” money, as some call it—on the short list. In particular: the annual percentage change in the real (inflation-adjusted) monetary base. For perspective, consider how the base (let’s call it M0) has fared over the past half century after deflating it by the consumer price index and calculating the changes vs. year-earlier levels:
Note that the annual fluctuations in the real M0 tend to go negative either just before or during the early stages of economic recessions. No one should assume that this metric is flawless as a business cycle indicator, but it’s hardly irrelevant either. The dip under zero in late-2010, for instance, didn’t lead to a recession. Then again, M0’s descent was brief. It’s not obvious that trouble would have been avoided if a longer-lasting visit to negative terrain had prevailed.
The chart above ends in July 2008. Why? Because shortly after that date, the annual changes in the base exploded to the upside, courtesy of the Fed’s monetary reaction to the Great Recession and the financial crisis in the fall of 2008. As such, the scale changes dramatically. Here’s how recent history stacks up:
The monetary base may not be the last word on business cycles, but it’s a safe assumption that if M0’s year-over-year changes remain negative, the risk of economic trouble almost certainly will increase—all the more so if M0’s rate of contraction deepens in the months ahead.
It’s not inconceivable, however, that we may see offsetting factors in the near-term future, in which case the slightly negative change in M0 of late may turn out to be noise in the grand scheme of the business cycle. The Fed’s FOMC meeting next month (Sep. 12 and 13) comes to mind. Will the central bank launch a new round of quantitative easing and effectively reverse M0’s descent? Some analysts are calling for no less, including Boston Fed chief Eric Rosengren.
If QE3 is coming, the contraction in the monetary base may not be long for this world. But if the decline has legs, macro risk could be headed higher.