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Should We Be Worried About Rising M3?

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Let me make a wee confession: I tend not to follow money supply figures closely, in part because I am not a fund manager (there are only so many things you can watch on the side) and in part because we are missing some key underpinnings that might help make it a useful metric.

In the stone ages of fairly heavily regulated financial markets, Paul Volcker made a very effective use of managing money supply to choke inflation. Unlike Greenspan, Volcker was almost laconic, but Wall Street stopped every Thursday to read the weekly money supply release to see what the central bank was up to.

After Volcker, the use of money supply targets fell into disfavor because they reportedly started behaving less reliably. The stated reason was with so many new financial products, forms of near money were proliferating, making the old measures obsolete (one might argue that they changed the velocity of money in unpredictable ways). Of course, the Fed might have attempted to understand the implications of these new instruments, but as far as I know, that question was not studied in any depth.

In today’s Telegraph, Ambrose Evans-Pritchard looks at rapidly growing M3 and concludes the increase in the last six months isn’t a cause of worry, since it appears to be largely the result of worried investors fleeing to money market funds, CDs, and other highly liquid instruments rather than central bank actions. I decided to feature this piece in part because we have the rare spectacle of Evans-Pritchard arguing a “don’t worry” position while still getting in a few digs at the Fed.

From the Telegraph:

Professor Charles Goodhart – (Goodhart’s Law, ex Monetary Policy Committee, and now Olympian sage at the LSE) – is too polite to say that the Federal Reserve has made an utter hash of the US economy by slashing interest rates to 2pc. But that is clearly what he thinks.

“I would have done exactly the same as Bernanke given the financial crisis they were in,” he told me this week, sticking to the “mutual admiration” etiquette of central bankers. Then comes the sting.

“The M3 money supply is rising very rapidly indeed. There has been a very expansionary increase in the size of balance sheets,” he said.

The professor warned that yields on 10-year Treasuries (now 3.79pc) have shot up so much on inflation fears since the Fed bail-out in March that the effect risks short-circuiting the whole monetary rescue. “They may find that they don’t benefit after all from cutting rates,” he said…

The Fed may now be trapped. The argument is that the US 10-year rate – set by market forces, and increasingly by the actions of Chinese and Mid-East governments – is the key price setter for the US housing market and corporate debt. Mess with bond vigilantes at your peril.

Mr Goodhart warns that the Fed’s “ideological” attachment to core inflation – which strips out food and energy – could lead them up the creek this time…. “The Fed thinks that headline inflation (3.9pc) will come back down to core inflation, but this time core may go up to headline,” he said…

I flag these comments because they touch on the most neuralgic issue of the day. My own view – if I dare dissent from the professor – is that the M3 surge is a false alarm. Needless to say, the Fed has not helped matters by abolishing the data.

Paul Ashworth, US economist for Capital Economics, has reconstructed the M3 figures using the old Fed model. They show that the M3 growth rate has jumped from 8.1pc to 14.9pc since the credit crunch began in August – high, but nothing like the claims of 30pc that are bandied around.

This rise is almost entirely due to a “bearish” flight from stocks and suchlike. Nervous investors have parked their wealth in money funds for safety until the crisis blows over. These money funds are distorting the M3 data (as Prof Goodhart also recognizes).

“Everybody keeps saying the Fed is dropping money from helicopters and flooding the economy with liquidity, but it is not true. All that is happened is that the precautionary demand for money has gone up. That is not inflationary in any way,” said Mr Ashworth.

Indeed, if you look at the narrower M1 money supply, which the Fed does control, it has actually fallen 0.7pc over the last year. The monetary base is contracting.

This chart from the Saint Louis Fed sent to me today by a reader came as a shock. The slide is getting worse. Perhaps that is why gold is down $125 an ounce from its peak in March.

It reinforces my fear that we are heading into a deflationary crunch. No doubt the Fed, ECB, the Bank of England, et al, will ultimately flood the system with money and set off another asset bubble. We are not there yet.

So let me throw it open to any readers who have a view: do we really face galloping inflation in the Atlantic and Japanese economies (still almost 60pc of world GDP), or is deflation lying in wait?

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  1. ruetheday

    Good post. Don’t worry, the rise in M3 isn’t due to the Fed’s monetary policy, it’s due to a sudden jump in hoarding, i.e., an enormous spike in liquidity preferences, so we have nothing to worry about. Oh wait, nevermind.

    The credit crisis is over. Not.

  2. S

    Credi is a future call on money, period (unless you are the US governement and can permantenly roll over and expand – which history says always ends badly). So the Fed is merely playing a horizon pushing game, with no strategy. Tactics without strategy is the surest way to failure. No one really knows what the collateral at the Fed or the ECB for that mater is worth. All speculation at this stage. But assuming it is not money good (at least in part, then either the banks will have recaped themselves sufficiently in the interim (BAC raised another $2.5B last night) to essentially take the losses and power on maybe in 2012 or so. The implication of this route is long and slow (see Mitsibishi UJF comments on slowing lending last night). Trichet is arguing for a dose of tough medicine while Bernanke obviously believes the system to be so teminal it can’t handle such a move now or anytime soon. The notion that the Fed actually raises is equally laughable. On second thought, expect an expansion of the TAF by another 50 billion if a raise does occur. We are already in deflation albeit masked by a screaming desire to protect oneself from the leavy hand of bernanke. The Fed has only one option and it is to print and print a lot. The real pain will come when its over and the inevitable sets in, which ironically will usher in an era where things are actuially aligned with fundamentals. How novel.t

  3. Anonymous

    Even though Evans-Pritchard is right that the current high M3 has come from a flight to safety, isn’t it inflationary because of where this money will go in the future?

    Doesn’t the high M3 represent excessive printing in the past?

    Isn’t Bernanke shrinking M1 to try to mop up some of this past excessive printing?

  4. Marcf

    Inflation = At constant offer, constant demand, the prices spike because all agents in demand are offering higher prices.

    The current M3 increase isn’t inflationary because there is NO demand for assets at the moment.

    M3 incrase does not represent printing in the present while it has in the past.

    M3 may be “bubble inducing” in a particular asset class. There is still significant mass out there that it will create a localized bubble. See on-going threads on this blog about “liquidity inducing bubbles”

  5. David Pearson

    Seems the posters here understand it better than Evans-Pitchard. M3 may be irrelevant from the standpoint of current Fed policy, but it does reflect the past. Money created by the Fed flowed into credit. Now that we’re de-levering, some of that money is being destroyed, and some is looking for a new home in hard commodities.

    So what we’re seeing is “pent-up” inflation from previous monetary expansion. This is an interesting phenomenon because, for the time being at least, both the deflationist (credit is being destroyed) and inflationist (prices are rising) camps are right. Evans argues the deflationists will prevail before the Fed really inflates. Maybe, but its also possible that we are in a decade-long inflation as the Fed fights unemployment with accommodation.

  6. Max

    Mess with bond vigilantes at your peril.

    LOL, that’s the stupidest thing I’ve ever heard. China will always hoard US bonds at whatever price.

    As dumb and irresponsible our Fed may be, they are a distant second from the Asian governments.

  7. James

    Yea, it really is amazing what Asia is doing. i suspect the public knows very little of what is going on or its gradually leaking out. China is still super corrupt. Its essentially stealing its citizens savings to lend to the US so we can buy nike’s. How is that a good strategy for the longterm?

  8. Flow5

    The DIDMCA laid the legal framework for the addition of 38,000 commercial banks to the 14,000 we already had. In doing so it also blurred all deposit classifications.

    The evidence of inflation is represented by “actual” prices in the marketplace. The “administered prices would not be the “actual” market prices were they not “VALIDATED” by (MVt)

  9. Anonymous

    David Pearson, I second your observations and will add a third:

    Finally, the U.S. economy now faces the prospect of inflation and recession at the same time, “partly because the dollar has ceased to be accepted as the reserve currency it has been” in the past, Soros said.

  10. mock turtle


    i’m a little confused

    i can see the argument pro and con regarding M3 growth…does or not matter.

    but the fact is M3 is soaring

    and so is M2…469 billion dollars in the past year

    so why the argument…or rather the emphasis on M1…yeah it’s been static this year…so what

    M2 is up over 7% y o y

    M3 is arguably twice that

    meanwhile the commodities we MUST have (no not running shoes and plasma tv ) food and energy are skyrocketing.

    M2 M3 growth and rising food and energy costs spell inflation

    slowing economy at home is stagnation

    STAGFLATION is our future. NO?

  11. Max

    China is still super corrupt. Its essentially stealing its citizens savings to lend to the US so we can buy nike’s. How is that a good strategy for the longterm?

    It’s not, and the food and inflation riots in China is a testament.

    But hear this – it will take a lot more than voices of the disenfranchised citizens for China to change their ways. It’s not in their culture to admit a major f-up, losing face is worse than death.

    Therefore, as long as there is Asia, nobody should worry about the mythical bond vigilantes.

  12. Flow5

    What goes for M2 also goes for M3. M2 erroneously includes MMFs in its definition (a sizable #). MMFs are the customer’s of the commercial banks. They are financial intermediaries/transmitters. Monetary savings are never transferred from the commercial banks to the intermediaries; rather are monetary savings always transferred through the intermediaries. Whether the public saves or dis-saves, chooses to hold their savings in the commercial banks or to transfer them to intermediary institutions will not, per se, alter the total assets or liabilities of the commercial banks; nor alter the forms of these assets or liabilities.

    Financial intermediaries (MMFs) lend existing money which has been saved, and all of these savings originate OUTSIDE of the intermediaries (depend on an inflow of savings to finance loans). The utilization of these loan-funds, or the activation of monetary savings held by these financial intermediaries, is captured thru the velocity of their deposits (bank debits/withdrawals), and not thru the volume of their bank deposits. I.e., from the standpoint of the economy, MMF deposits never leave the MCB System. And the growth of the MMFs is prima facie evidence that existing funds/savings have already been saved/invested/spent, i.e., transferred/transmitted by their owners/savers/creditors to borrowers/debtors. I.e., this currently (but not for ever) represents a double counting, and will continue to be so, as long as these intermediary financial institutions don’t practice/conduct a transaction’s deposit business.

  13. Flow5

    It is a succulent irony that professional economists, (those who confuse the supply of money with the supply of loan-funds), thus conclude that increases in the old monetary figure “L”, (or M2, or M3), are inflationary. The conclusion is tantamount to saying, “don’t save money” as savings (which we don’t have enough of) adds to “L” and therefore has an inflationary bias, when in fact, savings (a large portion of “L”) is evidence of money that has already been saved/spent/invested. Savings-investment accounts have been lumped into the Keynesian inspired concept of money (as are MMF funds).

  14. Scott

    RE: bond vigilantes and China

    Brad Setser recently pointed out that PBoC has over $500 billion in US agency debt…that is to say in US mortgages. So they are going to lose their shorts on this investment due to foreclosure/defaults. If they stop buying agencies, the price drops sharply and they get a big loss on their current holdings. Chinese financial authorities have boxed themselves in rather tightly, it seems.

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