M2 Growth Falls to 3.7%; Can That Signal Inflation?
Can this really be an inflationary environment with annual M2 money growth at close to the lowest level in 14 years, now at only 3.7% (data here)?
CARPE DIEM
Professor Mark J. Perry's Blog for Economics and Finance
Saturday, December 26, 2009
About Me
- Name: Mark J. Perry
- Location: Washington, D.C., United States
Dr. Mark J. Perry is a professor of economics and finance in the School of Management at the Flint campus of the University of Michigan. Perry holds two graduate degrees in economics (M.A. and Ph.D.) from George Mason University near Washington, D.C. In addition, he holds an MBA degree in finance from the Curtis L. Carlson School of Management at the University of Minnesota. In addition to a faculty appointment at the University of Michigan-Flint, Perry is also a visiting scholar at The American Enterprise Institute in Washington, D.C.
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27 Comments:
Japan is in deflation, and we were lucky to sidestep that fate too.
Office rents, factory rents and housing all soft. Labor is dead. Prices of manufactured goods (except military hardware)fall every year.
What inflation? Maybe health care, education. That's it.
Listen, the Bush Train Wreck nearly sent us into a global tailspin. Bank runs in America, and GM hat in hand just like a Banana Republic. Ouch.
Bernanke did a good job in avoiding worse, and the Obama team--well, at least they show up for work.
Good growth ahead in 2010, and inflation is deader than yesterday's newspaper.
Bernanke can print money until the plates melt. Actually, we need a long sustained round of moderate inflation to deleverage. Ain't no way either party is going to blanc the budget.
I wish M2 growth was higher.
Okay, I agree that M2 is telling us a non-inflationary story for the moment, but what about the future? We may all be dead in the long run, but I plan on being around for a few more decades. What I would like is for someone to paint a reasonable, non-inflationary scenario for what's going to happen to the massively inflated monetary base. The monetary base has more than doubled. Doesn't that have to come into the economy at some point, and cause price inflation. What is the scenario that would stop that from happening? I've asked this question before, in many places, but no one answers. Kind of gives me the feeling that those who are telling us not to worry about inflation are just whistling past the graveyard. Would love to have some reason to think otherwise. Well, how about it? Someone? Anyone?
Mark,
using the same methods by which you pointed out in several past comparison: M2 growth is at the same levels as in 2002 or 2004. Was that signaling inflation?
The steep rise in the monetary base isn't inflationary, because banks aren't lending much. Banks are building-up their capital reserves or ratios.
What may be inflationary is slower real growth, because nominal GDP minus real GDP is inflation, and U.S. trading partners are absorbing fewer dollars.
Also, I may add, the Fed is expected to preempt inflation, when the economy inflates enough.
Thanks Peak Trader, but that really doesn't scratch my itch. I basically know all that. I also know that the Fed is supposed to be able to manage this, but what seems iffy to me is the mechanism. I'd like to see someone paint a picture of how the mechanism will work, either to reabsorb the reserves or keep them from flooding out into the economy.
Perry, the Fed will sell bonds to banks, to drain dollars out of the commercial banking system.
Much of the inflation discussion assumes the Milton Friedman theory of money quantity driving inflation.
But how can you get wage inflation with 10% unemployment (except in some niches). With mfg running at low capacity utilization there is no shortage of goods, so no source for inflation there. With so much money disappearing into the foreclosure bucket, some of which is offset by bailouts, again hardly a source for inflation. Finally the second element of the quantity theory of money and inflation is the velocity of money and much of the created money is just sitting. Yes it could start moving, but when is the question.
So until you see unemployment down in the 6 to 7% range don't worry its unlikely to happen.
For longer range ideas, consult your tea leaves, or go to Delphi and consult the oracle, or similar ancient and well tested method of predicting the future.
Thanks Peak Trader. Next question -- why will the banks buy the bonds? Presumably the Fed will want to sell at a point when velocity (and therefore inflationary pressures) are on the rise, which would seem to be a time when banks would be less inclined to buy bonds. This would seem to imply, at the very least, that the bonds will have to be sold at a steep discount in order to attract the buyers needed to shrink the monetary base. Doesn't that imply that the Fed's balance sheet may have trouble reabsorbing all the cash?
To your question about flooding reserves, might the Fed be operating under the assumption that the Obama Administration is going to increase required reserves? That wouldn't be completely off base would it, with some of the rhetoric coming out of the White House?
I should say that CONGRESS would increase RR, as Obama Administration obviously doesn't have the power to legislate. But I do agree with you, at this point ER for banks is still far past what they can reasonably raise RR to.
Lyle, in the 1970s, there was 7 or 8% unemployment with 7 or 8% inflation, i.e. stagflation.
I stated above: What may be inflationary is slower real growth, because nominal GDP minus real GDP is inflation, and U.S. trading partners are absorbing fewer dollars.
Moreover, a supply shock, e.g. $200 oil or a spike in food prices, can be inflationary.
Perry, bonds are bought and sold on the open market, i.e. open market operations. The Fed creates and destroys money. Recently, it created money buying bonds.
However, what I expect is an illusion of prosperity. 2009 is a turning point where government placed massive inefficiencies in the economic system. So, Americans will get less for their work.
Recall that before stagflation there was a long period of rising inflation starting with LBJ, then we had the wage/price controls of Nixon, whip inflation now of Ford and then got stagflation. That took about 10 years to happen. Inflation did not shoot up but rose gradually to its high value.
The fed can continue to pay interest on bank reserves to control velocity. The fact that they were doing this when the Taylor rule would suggest even greater quantitative easing suggests to me that the fed is very serious about inflation. Here's the money multiplier which has declined. http://research.stlouisfed.org/fred2/series/MULT
Here's reserve balances with federal reserve banks.
http://research.stlouisfed.org/fred2/series/WRESBAL
So I don't think a graph of the monetary base tells the whole story.
http://research.stlouisfed.org/fred2/series/BASE
The market doesn't appear to expect out of control inflation based on the spread between treasury yields and TIPS yields, but Allan Meltzer says you shouldn't make inferences about inflation based on this because banks are buying up treasuries with the huge injections of liquidity. http://www.ustreas.gov/offices/domestic-finance/debt-management/interest-rate/real_yield.html
Lyle, I didn't say inflation shot up. Inflation is too much money chasing too few goods. We've done a good job destroying goods, including imports. However, the destruction began with excess goods, because the U.S. economy was most efficient, in creating and capturing goods in the global economy. Now, we just need to print or lend enough money.
There are no reserves at banks. Sure, the KC Fed charts say there is and sure the bank balance sheets say their is but credit card losses will end up being as much as or more than the current reserves.
See here: http://globaleconomicanalysis.blogspot.com/2009/12/fictional-reserve-lending-and-myth-of.html
I think Mish answers all your questions. I read both of you every day for some balance about the inflation/deflation theory. It would be great to get the two of you together to hash this one out.
James
Velocity stops because dollars go overseas in the form of trade deficits. The huge volumes of dollars not returning to the U.S. in the form of purchases may well result in another lost U.S. decade.
Velocity of money is a key indicator of vibrant multiplier activity.
Inflation could well start to rise and not becuase money growth is slowing. The reason will be the people's money (U.S. dollar) will continue to lose value and purchasing power.
My last paragraph above should have read: Inflation will start to grow despite falling money growth. The reason will be that the people's money (U.S. dollar) will continue to lose value; thus purchasing power.
(I wish we could edit for a short while after posting comments)
Gettingrational, those dollars come back in the form of investment. The problem is the dollars flow out from the private sector and come back to the government (when foreigners buy U.S. Treasury bonds). So, the government needs to give those dollars back to the private sector. That's why contractionary fiscal policy preceeded recent recessions (since the U.S. became an open economy). Also, I stated before:
Changes in fiscal policy can change the velocity of money. However, in the long run, V and T are constant. So, M equals P.
Also, I may add, in the equation MV = PT, if M and P are constant, then V = T, i.e. V, the velocity of money, or the number of times money is exchanged, equals T, the number of transactions, or the quantity of goods exchanged. The goal of monetary policy should be to keep actual GDP close to potential GDP, which smooths-out the business cycle creating optimal growth (since there's neither strain nor slack in the economy). The fact that there are monetary tightening and easing cycles, to close output gaps, are attempts to smooth-out T in the short-run. V and T fluctuate in the short-run, which require adjustments in M to stabilize P and smooth-out T. For example, if people decide to hoard money, then V and T will fall (in the short run). So, M needs to rise (higher than a constant growth rate).
Perry, I think you are right to worry. I don't think your questions have been answered.
I am not an economist, and by no means an expert, but from my reading of von Mises, Hayek, and Hazlit I believe that inflation is an increase in the money supply. Rising prices, including wages, are a reaction to that increase, not the inflation itself. as Peak Trader puts it "...Too much money chasing too few goods." causes prices to rise.
I believe the M3 money supply (which is no longer published) would show the inflationary signs you are looking for. When banks stop de-leveraging and start lending at a more normal pace, I think the M2 will show that also.
The reason banks are not lending more freely, and the reason businesses are not hiring, is most likely that few dare predict the future due to the shenanigans going on in Washington.
Many now believe that the Fed can't possibly guide something as complex as the US economy without causing unintended consequences at every turn. Witness the recent housing market bubble. Easy credit for a very long time caused distortions in the market. True, there are many other factors causing us to be where we are now, but I believe that Fed action is one of the primary causes of the current recession.
As Peak trader says, the Fed will sell bonds to banks, to drain dollars out of the commercial banking system. Why will banks buy these bonds, you ask? well, because they will carry an attractively high interest rate. This will in turn cause other interest rates to rise, as borrowers compete for scarcer funds, which will cause the economy to slow.
Peak Trader, We are saying the same thing as far as money leaving the country I think. Money leaves the country and returns in the form of treasury purchases instead of goods and services purchases.
Velocity of mnoney would grow dramatically if dollars were spent on U.S. Goods and Services. Instead it is dead-ended with foreign treasury purchases; most notably by China to keep yuan parity with the dollar. Obama should be hammering away at China to buy U.S. Goods and Services and let the yuan float.
I am afraid of a lost decade for the U.S. but with inflation because of the falling value of the dollar.
It's always a challenge to figure out where the Fed's newly-printed money will enter the economy and cause its mischief. Usually, it's through easy lending practices which drive up borrowing -- but that isn't working.
No, this time, the Fed is monetizing big chunks of the federal deficit. It's lending to banks at near zero and the banks are turning around and buying Treasury bonds. The newly-created money is entering the economy through the government's spending.
It's what happened during LBJ's administration setting off the inflation of the '70's and it's somehow fitting that it will be Obama's spending that will cause the inflation of the late teens.
I mean, why do you think the Chinese are running for commodities as fast as they can?
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For what it's worth, here are some of my rules of thumb based on my experience in capital markets…in short form. You need to follow things like yield curve, both broad and narrow monetary aggregates and some statistics on lending and lending standards in conjunction with each other to paint an accurate picture.
If you see more sudden, sharp changes to the broader aggregates (M2 and MZM), these are primarily a reflection of changes in money demand (reciprocal of velocity). They are portfolio changes and are based on changes in public sentiment. These moves correlate inversely with prices of risky assets and/or goods with non-sticky prices (stocks, commodities, etc.) eg. The recent decline in the rate of M2 growth is a reflection of the move back into risky assets after last year's panic.
The more gradual changes and long term changes in the broad aggregates are more a reflection of inflation pressures due to expansion or contraction of bank lending and the money multiplier. This is influenced by Fed policy as well, but it is imperative to look at growth rates in monetary base to see which direction the Fed is trying to push.
To tell an abbreviated story with the aggregates today, we see a Fed that is pushing as hard as it can to reflate (sharp increase in monetary base). The only impact that it has had so far (the recent declining rate of change in M2) is to improve confidence back from the edge of panic and move some money back into riskier assets. What it has not been able to do (yet) is improve confidence with banks or the public enough to encourage banks to be more aggressive with lending and/or encourage the public to borrow more money.
We don’t have conditions today that should remotely concern anyone about any excess inflation, in spite of what has happened with monetary base. Other than a decent improvement in overall confidence levels, the net result is just a change in broad composition of money supply, so that more of it is composed of monetary base than it has been in years…even then it remains a small part of the total.
The bottom line is that I agree with Mark.
Inflation happens continuously. The US government has increased its debt 9% annually since 1970. The public debt doubles every 6-12 yrs. Interest on the debt will soon be the most expensive item on the federal budget.
The prices for stocks, commodities, bonds, and real estate are determined by the ratio of buyers and sellers. Everyone wanted stocks in 1999 and everyone wanted real estate in 2005 so prices were high. Particular asset class prices have very little to do with inflation except that the average price of all dollar denominated assets is rising.
We will double the debt to $24 trillion before 2018. Eventually, no investors will want to hold dollar denominated assets unless they receive a very high interest rate. This will cause severe stagflation like the late 70s.
President Obama is like LBJ. His embracement of guns and butter will be purchased with more and more borrowed funds. The Vietnam war and the Great Society caused the stagflation that followed. It took 15 years for the fiscal mischief to reach peak economic pain. Presidents Bush and Obama together are at year ten, so I will not be surprised to see five more years of financial pain.
Investors will eventually refuse to buy this debt pushing up rates. High taxes will cause stagnation and stagflation is our destination.
Hey Anon,
Federal debt does not cause inflation, unless the Fed monetizes it (monetizing it when interest rates are near zero doesn't count).
Tough to argue that the Treasury is crowding out other investment with its borrowing when the 10 yr Note isn't even above 4%...
The other problem with history repeating itself like you suggest is that China and most Asian countries have made it a policy stimulate exports to overvalue the US dollar and MUST be willing to buy lots of US debt in order to pursue that policy... The second that they don't, they must allow their currency(ies) to appreciate...
I hear lines of argument similar to yours a lot, and while I understand the basis for it, I also wonder if these kinds of arguments were made for Japan for most of the last decade... Their debt as a percentage of GDP is much higher than the US, yet they continue to have incredibly low interest rates... Why is that? Not asking rhetorically...I don't know the answer and am curious...
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