Monetary Base, from Bill Rafter

February 26, 2010 |

There is a very big "shoot the moon" increase in the Base.

Bud Conrad comments:

Here is a chart from St Louis Fed of Monetary base

Bill Rafter adds:

Terse: a big increase in money stock (money supply). That would normally tend to be inflationary, but BSB just yesterday told us there is no inflation. (And he was correct.) Typically the Base tends to grow at an exponential rate in the low single digits. However with the banking rescue programs there was an astounding 100+ percent increase from Sept 08 to Jan 09, and another big increase from Aug 09 to Dec 09, and now we are at it again.

The reason there has not been inflation is that this expansion has not gone anywhere beyond the (big) banks. If you look at other versions of the money stock such as M2, you see that there has been no such increase. In fact, M2 has been showing contraction relative to its long-term target. It will be most interesting to see the M2 numbers to be released today. A big increase in M2 would make the case that inflation is finally coming. No increase in M2 would state that we are just getting more of the same, specifically that the Fed has been putting money out to the big banks (at zero interest) and then allowing them to simply leave that money on deposit with the Fed (at interest). This process is just a subsidy to the banks.

The important question to me now is why the latest increase? Are the banks in further trouble? Does this anticipate more trouble, say with commercial real estate?

Given the colossal increase in the Base, some of it will bleed through to M2, which probably explains the current increase. However note that M2 is still below its long-term growth rate (what I call the fit or target), so effectively practice (as opposed to policy) continues to be restrictive.

At some point "somethin's gotta give": The Fed could start taking down the Base. They probably will just reverse the policy of paying interest on deposits left with the Fed. At that point the banks will return much of their borrowings back to the Fed. Some of them may not, and choose to start pushing commercial loans out the door. Then you will start to see increases in M2 and the earlier increase in the Base will become inflation. That at present is the only reason why I watch this data.

Mick St. Amour comments:

Bill, this proves my theory that fed is fighting deflationary forces given contraction in lending and collapse in monetary velocity. Given we are in balance sheet recession, reflation of assets/collateral values is main goal of central banks everywhere. It is key to stoking animal spirits in the markets and in real economy. I suspect this provides tailwind for asset classes such as equities and commodities.

Rudolf Hauser comments:

It might be worthwhile to remind readers of what the demand for money is in a non-inflationary economy. It is the amount of money people in the aggregate wish to hold (emphasis on hold, not spend) plus that needed for transition in transactions (the amount involved that is held up by the clearing process) in an environment of just real growth or decline. That applies to both high-powered money (the monetary base) and measures such as M2. If that amount is not provided banks will attempt to increase reserves by reducing investments and loans. Paying interest on reserves increases the banks demand for reserves (excess reserves), as does increased caution on their part. You will only get M2 to grow if banks are more aggressive in investing and lending. Since there are no longer reserve requirements on (M2-M1) all of the reserves related to this are excess reserves. If the Fed were to stop paying interest on reserves a bank could profit from such reserves by buying 3 month or probably even 1 month Treasury bills as long as the return were in excess of their processing costs since the reserves used to buy those securities is zero percent financing. But to buy treasures they have to pay the buyer, which increases bank deposits, i.e., M2 (and M3). The banks cannot drain total reserves from the system– only the Fed can do that. If the Fed wants to keep excess reserves from being used it can discourage that use by raising the interest rate it pays on excess reserves. To repeat, lowering that interest rate only leads to more rapid monetary creation-something that I suggested would be desirable here to accelerate M2 growth to a rate that does not drive us into another economic down-leg in a few quarters from now.


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