Friday, August 19, 2011

Inflation Watch: News!

There is in fact something to report. Get it here, few others are going to have this news. It might mean something, it might not, but it at least is a change.

In a recent blog about the money supply I talked about how to read the graphs we get from the Fed, that to understand the meaning of the information, you needed to keep the steepness of the curve and the relative amounts in mind. Now we have a example of what I meant. It is a nice example for illustration purposes; it is a bad example if it foreshadows things to come.

The US money supply, as controlled by the Fed, is generally fed by way of bank loans. Generally, the level of bank loans is the best place to look first to get a good idea of what is happening.

Surprise, a graph! Well, you can see that the recent activity, after several months of steep decline, there has been some rebound, but that seems to leveled off, at least briefly. I put no importance on such brief changes, even though it is a little unusual. But, here is the important part, while BO has been railing at banks to loan money (regardless of his criticism that the financial meltdown was because banks loaned money – to the poor), the regulatory agencies, The Comptroller of the Currency and the FDIC, for example, have been engaged in very heavy handed tactics to force banks to adhere to what the regulators consider, sound banking practices. They insist the banks have lots of collateral and keep minute, intrusive records about the borrowers. Further, banks are still trying to replace the capital and loan loss reserves that disappeared in the meltdown. Those who carry on about bank profits just are not taking the responsibility to find out what they are talking about.

After looking at bank loans, lets see what the money supply is doing. Ee have a choice where we look, since there are a few different indicators. What the hell, lets look a several.

First is M1, which is the basic money supply category and includes all physical money such as coins and currency; it also includes demand deposits, which are checking accounts, and Negotiable Order of Withdrawal (NOW) Accounts. So, this is the money you use to buy stuff with.

M2 is a little broader, it includes M1 plus all time-related deposits, savings deposits, and non-institutional money-market funds. This is money that is one small step from the availability to be spent.

Then we have the one I consider most useful, MZM, which is all money in M2 less the time deposits, plus all money market funds. It measures the supply of financial assets redeemable at par on demand, or all the money that can be realily spent.

Also available from private sources (because the government stopped publishing it) is M3, which is M2 as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. The “other larger liquid assets” includes Eurodollars, which means here we can see the overhang that could drop on us. Eurodollars are dollars held in foreign, private accounts. Thus, this measure does not include dollars held by foreign central banks as reserves (if the money has been invested somewhere, and not just held as cash, it will show up in one of the Ms).

I showed you M3 for the sake of completeness, but for our purposes, in this post, let’s use the other three, focusing on domestic dollars.

I am sure that you can readily see that each seems to currently be heading straight up. Up until now, the graphs had been moving more or less on a trend line that was fairly consistent from the 1980s. These are linear graphs, meaning that a change of $100B at the bottom of the graph was the same size on the vertical axis as a $100B at the top. That means, from a practical perspective, that a recent $100B change in the money supply was not as significant as one 30 years ago. Today, $1000B is small potatoes. So if the graph was sloping the same angle, the rise in the money supply was having less and less effect.

Now, the slope has definitely increased. If it continues, the impact of the growth in the money supply will be greater. The question is, will it continue to grow at that rate or faster?

You might ask, well if the banks are not loaning more money and that is how the Fed pumps money into the system, how is the money supply expanding?

The answer to the question is that there three other sources of growth in the money supply (that have played little or no role hitherto): 1) In QE2, the Fed was playing a little with its processes and managing to get some money directly into the hands of the Treasury (see the several comments under “Making Claims About the Money Supply), and that expanded the money supply. Whether that explains this jump is unclear, at least to me. 2) Money that was in other instruments, and not available for immediate spending may have been moved. It would take a large and noticeable move to result in this jump, but this change could explain part of it. 3) Dollars kept overseas could have been moved back to the US. This is my choice. In the recent turmoil in Europe people and businesses have been fleeing the euro and the eurozone. We could easily see billions of dollars moved, not just into dollars, which has made the dollar “stronger”, but move to be deposits within the US.

If the last of my three options is the reason for the rapid increase in the money supply, I don’t think that it is sustainable and then not a threat for our consumer prices. The reason being that there is only so many dollars that can be moved quickly. There are many financial and business obligations overseas that are paid in dollars. If too many dollars come here, they will just have to go back. It would take time for those obligations to be unwound and the dollars freed up so that they could remain here. If that begins to happen, then we will see a significant influx over time and a consequent increase in dollars for asset investment and spending. We will either have another asset boom, a general consumer price inflation, or both.

But, in order for the role of dollars to begin declining in international trade and finance, there would have to be a replacement. People overseas would have to find a currency that they were willing to trust as much as they trust dollars today. It would have to be a currency that is as available as dollars are (a large quantity). There isn’t one. Nor is there one on the horizon. (I mean in terms of the recognition of the people overseas, not as a potential.) Therefore, if I am correct in my suggestion as to the source of the increase in the money supply, we need not worry about that problem right now. But we do need to keep our eyes on it.

But, we have to keep an eye on what the money supply is doing anyway. It isn’t optional, because it foretells what we will have to face.


  1. Interesting that you mention Eurodollars. I vaguely remember that name from somewhere. I wonder what is the amount of Chinadollars. I had a student who told me his business was paid in dollars by Japanese businesses. He had an account in a Chinese bank in dollars, something we can't do here with the RMB.

  2. Eurodollars began as a special pool of dollars held in Europe to facilitate trade and investment in countries whose currency wasn't readily traded. Since then, it has grown into an international market of dollars. The term doesn't refer to just Europe any more. There is a Eurodollar futures market and many foreign banks advertise for dollar deposits. Google eurodollar deposits and see what you get. There could be as much as $5T of dollars wondering around, according to M3. This money does not include the reserves held by central banks like China, who has about $1.4T, I think. Eurodollars also include the dollars being used in three or four small countries that do not have their own currencies and use dollars instead. You can go into almost any business, hotel, and especially any bank in the world and do buiness in dollars. You go into nearly any bank in the US and try to use anything but dollars and they won't know what to do. The dollar is the international currency, for good or bad.