Wednesday, September 20, 2017

What is the Supply of Money Telling Us About the Health of the Economy?

One of the Federal Reserve's key responsibility is monitoring the supply of money in the economy.  Through the mechanism of creating and destroying money, the Fed is able to impact economic growth levels.  Here's what the Fed has to say about the supply of money:

"The money supply is commonly defined to be a group of safe assets that households and businesses can use to make payments or to hold as short-term investments. For example, U.S. currency and balances held in checking accounts and savings accounts are included in many measures of the money supply.

There are several standard measures of the money supply, including the monetary base, M1, and M2. The monetary base is defined as the sum of currency in circulation and reserve balances (deposits held by banks and other depository institutions in their accounts at the Federal Reserve). M1 is defined as the sum of currency held by the public and transaction deposits at depository institutions (which are financial institutions that obtain their funds mainly through deposits from the public, such as commercial banks, savings and loan associations, savings banks, and credit unions). M2 is defined as M1 plus savings deposits, small-denomination time deposits (those issued in amounts of less than $100,000), and retail money market mutual fund shares. Data on monetary aggregates are reported in the Federal Reserve's H.3 statistical release ("Aggregate Reserves of Depository Institutions and the Monetary Base") and H.6 statistical release ("Money Stock Measures").

Over some periods, measures of the money supply have exhibited fairly close relationships with important economic variables such as nominal gross domestic product (GDP) and the price level. Based partly on these relationships, some economists--Milton Friedman being the most famous example--have argued that the money supply provides important information about the near-term course for the economy and determines the level of prices and inflation in the long run. Central banks, including the Federal Reserve, have at times used measures of the money supply as an important guide in the conduct of monetary policy."

That said, the Fed admits that the supply of money has become a somewhat less important indicator of economic health:

"Over recent decades, however, the relationships between various measures of the money supply and variables such as GDP growth and inflation in the United States have been quite unstable. As a result, the importance of the money supply as a guide for the conduct of monetary policy in the United States has diminished over time. The Federal Open Market Committee, the monetary policymaking body of the Federal Reserve System, still regularly reviews money supply data in conducting monetary policy, but money supply figures are just part of a wide array of financial and economic data that policymakers review." (my bold)

Here's a graph from FRED which shows how the supply of money using the M2 measure (sum of currency held by the public and transactions at depository institutions (M1) plus savings deposits, small-denomination time deposits (less than $100,00) and balances in retail money market mutual funds) has grown since late 1980:

Here is the same data showing the growth rate of the supply of money over time:

Note the rather clear connection between increased growth levels of the supply of money and recessional periods with the exception of the period after the 1990 - 1991 recession?  

Here's what has happened to the growth rate of the supply of money since the beginning of the Great Recession:

Note that the growth rate has dropped substantially over the past year from 7.9 percent in October 2016 to its current level of 5.2 percent.

Let's look at another way of measuring the supply of money.  According to the Austrian Money Supply Measure, a more accurate and broader money supply metric developed by Murray Rothbard and Joseph Salerno, a measure which is defined as follows:

Ma (a = Austrian) = total supply of cash-cash held in the banks + total demand deposits + total savings deposits in commercial and savings banks + total shares in savings and loan associations + time deposits and small CDs at current redemption rates + total policy reserves of life insurance companies—policy loans outstanding—demand deposits owned by savings banks, saving and loan associations, and life insurance companies + savings bonds, at current rates of redemption.

...the growth in the supply of money (blue line) has dropped to levels not seen since the Great Recession in August 2008:

As you can see from the graphic, during economic expansions, money supply as measured using the Austrian Money Supply Measure tends to grow at faster rates as banks loan out money to businesses and individuals.  During and prior to economic contractions, money supply tends to either contract or grow at far slower rates as banks loan less.  Therefore, it is somewhat concerning that the year-over-year change in the supply of money as measured using the Austrian method is showing its slowest growth in nine years.

We are seeing evidence of this problem in the economy.  Here is a graphic showing the year-over-year change in commercial and industrial loans going back to 1948:

Prior to or during each recession over the past 70 years, we see a decline in the growth rate of commercial and industrial loans.

Here we focus on the period since the beginning of the Great Recession:

You can quite clearly seen that the growth rate in commercial and industrial loans has dropped over the past 18 months from 10.6 percent in April 2016 to its current level of 2.2 percent.  While the reasons for this are unclear, it is quite possible that a less than robust economy is making it harder for America's commercial banks to find worthy borrowers.

While the Fed may state that all is well in the economy (with the possible exception of inflation that is well below its comfort level), this assessment shows that the Federal Reserve is walking a tightrope between further monetary tightening and creating the next recession.  At this point in the economic cycle and with the economy's addiction to cheap credit, the Fed finds itself in a very unenviable position.