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Money supply update -- so far, nothing much going on

The big news from the monetary front is that there is no news. M2, arguably the best measure of the money supply, is growing at the same pace as it has been for many years—about 6% per year on average. There is no sign of any unusual growth in the amount of money in the economy, despite the Fed's purchases of more than $1 trillion worth of securities (aka QE1 and QE2).

We do see the monetary base (currency plus bank reserves) growing recently, which is to be expected given the Fed's ongoing purchases of Treasuries, since they are paid for by creating bank reserves. But the extra base money is not translating into more money in the economy; the banks are just sitting on the extra reserves. This may be because the economy's demand for loans is not picking up, and/or because the banks are still reluctant to lend, preferring to accumulate reserves (a risk-free asset) instead of (risky) loans on their balance sheet.

This chart of excess reserves underscores the point: virtually all of the extra bank reserves the Fed has created in the past 2+ years are sitting idle at the Fed.

To simplify what has happened: the Fed has effectively swapped bank reserves for Treasury securities. This has reduced the amount of Treasury securities in the world and increased the amount of very short-term securities (bank reserves are similar as an asset class to T-bills; both are risk free and both pay 0.25% annual interest). The Fed has thus assumed a good deal of interest rate risk, because the price of its security holdings will decline if interest rates rise. At the same time the world has reduced its interest rate risk by a corresponding amount.

To date, this all looks like a deal struck voluntarily by consenting adults, with no apparent inflationary consequences (since a permanently and significantly higher price level would require a permanent and significantly greater amount of M2 money). However, this is very unlikely to be a long-term equilibrium situation. Banks could decide to deploy their reserves to expand their lending, which in turn could pump a lot of additional money into the system. Can the Fed reverse course in time to prevent a serious buildup of inflationary pressures? Bernanke says yes, but the proof will be in the pudding, as they say.

Meanwhile, the action in the FX, gold and commodities markets suggests that a lot of people are looking to get protection against a decline in the dollar's purchasing power, and that is a classic symptom of an inflationary problem in the making. The dollar has fallen against other currencies, and gold and commodity prices have risen, because the world is uncomfortable with the amount of dollar exposure it has. This is another way of saying that while the Fed's actions haven't resulted in any unusual expansion in the supply of money, the world's demand for dollar money has declined. Weak dollar demand can cause inflation just as easily as excess dollar supply, if the Fed does not take steps to soak up the unwanted dollars, or to increase the world's confidence in, and desire to hold dollars.

Much remains to be seen, and this potentially huge source of monetary uncertainty is still weighing on nearly all markets. Monetary uncertainty and fiscal excess (i.e., too much spending and the threat of higher tax burdens that this creates) are acting like significant headwinds to economic progress. It's a vicious circle, since the weak economy that results from all this uncertainty only encourages more of the same. We really need some convincing action from Congress to cut the size and burden of the government, and from the Fed to reverse its quantitative easing. The sooner the better.

Rising rates pose no threat to growth

The 130 bps rise in 10-yr Treasury yields that has occurred since October has resulted in a slightly smaller rise in MBS yields, and in an even smaller rise in the cost of conforming 30-yr fixed rate mortgages. As these charts show, yields in general are still quite low from a recent historical perspective, and MBS spreads are also still quite low.

The main driver of higher yields is a stronger economy. If the Fed were driving yields higher and if the yield curve were flat or inverted, then you could say that higher rates posed a threat to growth. But we are a long way away from that—it could take years before higher rates threaten the economy. For now, higher rates are welcome because they reflect stronger growth and stronger loan demand.

Federal revenues continue to outpace spending

The January budget figures confirm the big story that not many have heard: federal revenue growth has been outpacing spending for more than a year. The 12-month rolling sum of federal revenues rose 10% over the past 12 months, and it rose at a 10.7% annualized pace in the past six months. Meanwhile, the 12-month sum of spending hasn't budged at all since Oct. '09.

This is not an unpredictable outcome, though many have ignored it. Recoveries typically result in a slowdown in spending (fewer people receive unemployment claims) and a pickup in revenues (more people working, rising corporate profits, rising capital gains realizations). Since the current recovery began, the deficit as a % of GDP has declined from a peak of 10.3% to 8.6%, and the 12-month deficit has declined to $1.28 trillion in January, down from a high of $1.48 trillion last February.

If Congress can hold the line on spending, and if the economy picks up a little speed, we could see the deficit fall to 7-7.5% of GDP by the end of this year. We would still be a in mess of trouble (adding at least another $1 trillion to the national debt as interest rates rise), but we would be making progress. Better fiscal policy from Washington would help improve confidence, which in turn would boost investment and job creation, which would then reinforce the positive developments in receipts and outlays that are already taking place. We are not at all in a hopeless situation.

Inflation, deflation, and China

The debate over deflation vs. inflation continues, and this chart shows one good reason why: they both have been with us for the past 16 years.

As I first pointed out in a post last May, 1995 marked the point at which—for the first time since the data were collected beginning in 1959—the prices of durable goods (e.g., cars, computers, TVs, equipment) started declining, while nondurable goods (e.g., food, energy, clothes) and services (e.g., plumbers, accountants, banking) kept rising. Since then we have seen the prices of services rise by 55% and nondurables by 40%, while the prices of durable goods have fallen by 25%. So although we are paying more for food, energy, and plumbers these days, we are paying less for the technological prowess and capabilities of those beautiful flat-screen TVs and awesome iPads.

Meanwhile, over the same period, disposable personal income per capita in the U.S. has risen by 84%. This means that an hour's worth of work today buys about two and a half times as much in the way of durable goods as it did 17 years ago. That's an incredible and unprecedented development, and we have the Chinese to thank for much of it. This also underscores how important global trade can be to prosperity: the Chinese have risen out of poverty and U.S. consumers' living standards have improved.

Not coincidentally, 1994 marked the beginning of the modern era for the Chinese economy. The yuan suffered a 33% devaluation against the dollar in early January, 1994, but following that it was pegged to the dollar for 11 years. China's monetary policy was thus effectively outsourced to the Fed, and China's inflation rate fell from almost 30% in early 1994 to zero by 1998 as a result. Thanks to a strengthening currency, low inflation, and market-liberalizing policy moves, China's economy since 1994 has quintupled in size, propelled in part by explosive growth in its exports of cheap manufactured goods. China has supplied us with cheap goods, allowing us to spend more on other things and thus raise our living standards. To be sure, China has bought a lot of our Treasury debt, but that has allowed them to create one of the strongest currencies in the world; a devaluation of the yuan today is almost unthinkable. Strong currencies beget strong economies, and China is allowing the yuan to strengthen further against the dollar. Meanwhile, in exchange for cheap TVs, computers and cellphones, we have supplied China with capital, technology, movies and software, among other things. It's been a match made in heaven.

Commodities continue to rise

The above charts represent the two major components of the CRB Spot Commodity Index. Commodity prices continue to head skyward across the board, with most commodities hitting new all-time highs.

Arab Light Crude, flirting with $100/bbl, is now clearly higher in real terms than it was in the early 1980s. At this level, further price increases should begin to curtail demand, while also stimulating new sources of supply. But we are still well below the levels that might provoke a significant slowdown in economic activity, thanks to technological advances and energy conservation efforts.

Rising commodity prices continue to attest to a) strong global demand, and b) speculative activity fueled by easy/cheap money. Commodities are becoming increasingly vulnerable to any sign that monetary policy may begin to reverse course and seek to push short-term interest rates higher. I don't think this is imminent, but it is the clearest source of risk for commodity investors.

Great progress on the claims front

Progress on the claims front is really becoming visible. First-time claims for unemployment (seasonally adjusted) have now dropped over 40% from their early-2009 high, and are only about 50,000 above the average level of 2005, when the economy was growing at a decent pace and labor market conditions were "normal." It might not take much longer for claims to fall another 50,000—the 4-week average of claims has fallen by 50,000 in just the past 5 months, for example.

This dramatic improvement in claims is the necessary precursor to a pickup in hiring. Companies have made tremendous adjustments in the past few years, trimming their workforce and cutting costs in order to survive. The economy has largely adapted to the new realities (e.g., there is still a surplus of housing, and residential construction is going to be very low for some time to come); workers are shifting to new industries with more growth potential; and companies are accumulating profits and waiting for new opportunities to present themselves.

The big drop in claims suggests we are getting much closer to the time when there is no more need for adjustments and belt-tightenings, and expansion plans will come to the fore. If Congress can make significant progress towards trimming federal spending, thus assuring investors and business execs that future tax burdens won't surge, and regulatory burdens will more likely ease than increase, then we could see some impressive job gains before the year is out.

UPDATE: One more (anecdotal) sign of how much things have improved: my cousin finally landed a job after searching hard for the past two years. And no sooner had he started than he was called to interview for another, better-paying job.

Rising bond yields signal a stronger economy

It's fascinating to watch bond yields and equities rise. Bond have been rising since the end of August, which also happened to be the time when the Fed first floated the idea of QE2. I've said before that if there was anything helpful about QE2, it would be that it effectively quashed the fears of deflation. Without deflation to worry about, the market's level of confidence in the future increased, and that in turn unleashed new jobs-creating investments. But I think there is more at work here than just the death of deflation. The politics of the electorate has undergone a huge shift; there was a major change in the balance of power in Washington; Congress is now debating how much to cut spending, not whether to raise taxes. Moreover, corporate profits have been strong for quite some time and continue to increase; business investment (capex) has been growing strongly for the past year; and businesses have undergone major adjustments in how they operate, with the result that costs have been slashed and the productivity of workers has been very high.

So rather than laud QE2 for successfully boosting the economy, I think it makes more sense to recognize that natural forces of recovery have been building for a long time, well before QE2 was first floated. This is a genuine recovery, not a figment of Fed policy, and as such it has a lot more staying power than most skeptics imagine.

It's also worth noting that two Fed governors (Fisher and Lacker) today expressed deep concerns about the wisdom of continuing the QE2 program, citing the economy's obvious improvement in recent months and the increased signs of impending inflation.

Stock prices and Treasury bond yields represent the collective wisdom of hundreds of millions of investors who control scores of trillions of dollars worth of assets. Prices and yields are rising because the outlook for the economy is improving daily. The Fed cannot ignore these powerful fundamental forces for much longer.

Small business optimism coming back slowly

This chart of small business optimism puts into perspective just how awful things have been for the past several years. Since 1974 we've had six recessions, but none have come even close to the distress caused by the last one. Plus, the recovery from the last recession has taken far longer than any others. Nevertheless, it remains the case that things are improving on the margin, and that's what is most important today. Lots of room for improvement still, but we're on the right track.

Bond market to Fed: you've got things turned around

This chart of 5-yr Treasury yields is a companion to the Vix/S&P 500 chart in my previous post. It illustrates the market's amazing reaction to the Fed's QE2 program, which was first implemented in early November. Contrary to what the Fed thought—that QE2 purchases of Treasuries would depress interest rates and thus help stimulate the economy—the beginning of QE2 marked the exact bottom for 5-yr Treasury yields, which are center-mass for the bond purchase program. It wasn't supposed to happen that way—Fed purchases were supposed to keep rates from rising, not make them rise. And since the end of January, yields have risen almost 40 bps, as better economic news has caused investors to move forward their expectations for an end to the Fed's quantitative easing efforts, and to move forward their expectations for a beginning to an eventual Fed tightening.

So the Fed had the logic and the sequence of events wrong. QE2 didn't lower interest rates, and therefore it hasn't stimulated the economy. Moreover, QE2 so far has had little discernible impact on the money supply. This leads to the conclusion that the economy was improving on its own, well before QE2 could have had any meaningful impact. Plus, this whole episode illustrates powerfully how economic fundamentals and market forces can overwhelm the efforts of mere Fed governors.

Fear declines, prices rise

One more update to one of my favorite charts since late 2008. It reminds us that there are several things driving the stock market higher, and a decline in fear and uncertainty (represented by a decline in the Vix index) is definitely one of them. The Vix is still higher than it would be if calm, confidence, and tranquility reigned, but it is getting close to what might be considered "normal." Meanwhile, the return of confidence is being propelled by an improving outlook for fiscal policy (the debate now centers on how much spending to cut, not whether to cut spending or raise taxes); and an improving outlook for the economy (corporate profits remain very strong, manufacturing is improving dramatically, even the service sector is picking up).

The one remaining source of uncertainty is monetary policy. As the outlook for the economy improves, commodity prices continue to move higher, and the dollar languishes near its all-time lows, more and more people are calling into question the need for QE2. Shouldn't the Fed be pulling back already? Allan Meltzer had another good op-ed on this subject in the weekend WSJ, "Ben Bernanke's 70s Show," in which he concludes that

The Fed should make three changes. First, it should increase the short-term interest rate it controls to 1%, which would show that it is aware of the inflation risk and will act promptly to counteract it. Current low interest rates are an opportunity for the Fed to start reducing excess reserves.
Second, it should announce a specific, detailed plan that explains how it proposes to reduce about $900 billion of the more than $1 trillion banks continue to hold in excess of their legally required reserves.
Third, it should end QE2, its latest round of Treasury bond purchases. If, last November, the Fed had waited two more months before starting QE2, it would have known that a double-dip recession was not about to happen. Instead of waiting, the Fed responded to the cries coming from Wall Street.

So the world is still far from perfect, and there are still many things to worry about. But that also means that prices for risky assets are still likely somewhat cheap.