Money Supply Firing on All Cylinders?

by Michael Pollaro

Recently by Michael Pollaro: The Bernanke Arbitrage

Our monthly Monetary Watch, an Austrian take on where we are on the monetary inflation front and what’s next…

Headline Monetary Aggregates, Where We Are

The U.S. money supply aggregates based on the Austrian definition of the money supply, what Austrians call the True Money Supply or TMS, continued their recent surge, in December posting an annualized rate of growth of 38.9% on narrow TMS1 and 24.6% on broad TMS2. That brought the annualized three-month rate of growth on TMS1 and TMS2 to 22.3% and 18.1%, respectively, 8.6 bps and 2.7 bps higher than those posted in the prior month. No doubt some of this surge is seasonal, but as discussed below, clearly underpinned by the money-printing efforts of not only the Federal Reserve but of private banking institutions too.

Turning to our longer-term twelve-month rate-of-change metrics – more indicative of the underlying trends – and focusing on our preferred TMS2 measure, we find that TMS2 saw another healthy increase, in December growing at an annualized rate of 9.9%. Not only was this a tick up from November’s 9.8%, but we think close enough to 10% to mark December as the 23rd time in the last 24 months that TMS2 posted a twelve-month rate of growth in the double digits. For new readers of the Monetary Watch, the last time TMS2 saw this kind of string was during the run-up to the now infamous housing boom turned credit implosion, a time during which TMS2 saw 36 consecutive months of double-digit growth.

In what could be a developing trend, M2, the mainstream’s favorite monetary aggregate, is finally starting to show some growth. In the three months ending December, M2 has grown at an annualized rate of 9.5%, bringing its twelve-month rate of increase to 3.6%. Yes, 3.6% is still a relatively low rate of growth, but it is up substantially from its March low of 1.3%.

As readers of this site are aware, THE CONTRARIAN TAKE posits M2 as a grossly misleading measure of the money supply. So the question is, why do we even care? The reason, because the mainstream cares. They think M2 is a perfectly fine measure of the money supply, including the world’s most powerful money printer, Chairman Bernanke. And as we argued in The Bernanke Arbitrage, when the world’s most powerful central banker, armed with the world’s largest printing press, the same central banker who seems to think that economic prosperity can be achieved by printing money, thinks that the rate of monetary inflation is “low,” even when its not, he’s apt to print even more. So, with M2 quite possibly on an upward trajectory, the question to ask is this – will an upward trajectory in M2 give Bernanke some pause, perhaps give him a reason to slow his QE efforts and in turn slow the growth in the money supply? We doubt it, not at 3.6%. In fact, given that core consumer price inflation is still low, the unemployment rate still high, the real estate market still on the ropes and, as Bernanke testified to the Senate Budget Committee on January 7th, municipal debt problems becoming a concern of the Federal Reserve, we could almost guarantee it. Clearly though it’s something to watch.

Money Supply Firing on all Cylinders?

At THE CONTRARIAN TAKE, we put a lot of effort into dissecting the components of TMS2. We think it’s an important tool in deciphering the underlying trend in the money supply. Our favorite component views are what we call TMS2 by Source and Economic Category, views which zero in on the who and the how behind the ebb and flow of the money supply. Under this view, monetary inflation can be reduced to two basic institutions and three primary venues:

• The Federal Reserve, via the issuance of what Austrians call covered money substitutes: the simultaneous issuance of on-demand bank deposit liabilities and bank reserves by the Federal Reserve, created through its purchase of assets, by writing checks on itself, and later, when those checks are deposited by the sellers of those assets in their respective banks, completing the issuance by crediting those banks’ reserve balances at the Federal Reserve for the full amount of the checks.
• Private banks, via the issuance of what Austrians call uncovered money substitutes: the creation of on-demand bank deposit liabilities by private banks unbacked by any reserve cover, created through their issuance of loans and purchase of securities when they pyramid up those loans, securities purchases and deposit liabilities on top of their reserves.
• The Federal Reserve, via the largely passive issuance of currency: the issuance of Federal Reserve notes, created when the public chooses to redeem their on-demand bank-issued deposit liabilities for currency. In contrast to covered and uncovered money substitutes, the issuance of Federal Reserve notes is by and large neutral with respect to the total money supply, as it simply substitutes one form of money, namely covered and/or uncovered money substitutes for another, namely currency.

The combined total of covered money substitutes plus currency is what economists call the monetary base. And the issuance of covered money substitutes is more popularly known as quantitative easing or QE.

Now, while the Federal Reserve can create money via the issuance of covered money substitutes at will and without limit, it can only do so on a one-to-one basis; i.e., one dollar of asset purchases or QE can only bring forth one dollar of money supply. So, even though the Federal Reserve’s money printing powers are unlimited, there is not much bang for the buck. In the case of private banks it works the other way around. Under the law of the land, the private banking system can create money – uncovered money substitutes – at a multiple of their reserves at current reserve requirements, at a multiple of at least ten to one. Bang for the buck. Problem is, the buck stops when those private banks max out their reserves. The trick then, to get the money supply firing on all cylinders, is to get everyone involved, everyone working together as a team – the Federal Reserve supplying the QE fuel, and the private banking system taking that fuel and pyramiding up the money supply.

Where are we today? Well, for the first time in quite a while, the Federal Reserve and the private banking system are finally teaming up.

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January 21, 2011

Michael Pollaro [send him mail] is a retired Investment Banking professional, most recently Chief Operating Officer for the Bank's Cash Equity Trading Division. He is a passionate free market economist in the Austrian School tradition, a great admirer of the US founding fathers Thomas Jefferson and James Madison and a private investor. He is a columnist on the Forbes blog.

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