The Growing Disconnect Between the Supply of Money and Economic Growth

There is no doubt, economically, things are performing differently than one would expect, particularly given that the Federal Reserve has been actively intervening since September 15th, 2008 when the Fed began to inject massive amounts of credit into the market.  Between September 15th and January 2009, the monetary base doubled, an unprecedented move that showed how desperate the situation was after Lehman Bros. filed for bankruptcy protection.  In mid-March 2009, the Fed announced the first of its non-conventional policies known as QE1, signalling to the market that it would purchase up to $1.75 trillion in mortgage-backed securities, government agency debt and longer-dated Treasuries.  QE1 was followed by QE2, Operation Twist and QE3, all of which have led to monetary distortions that have not been seen before as you will see in this posting.

M1 is composed of the most liquid components of the supply of money and includes all physical money, demand deposits and checking accounts (i.e. those components of the money supply that can easily and quickly be converted to currency.  Now, let's look at what has happened to M1 since 1975:

You'll notice that M1 grew at a far more rapid rate during and after the Great Recession.  Since the beginning of the Great Recession in December 2007, M1 has grown by $1.326 trillion or 95.7 percent to its current level of $2.712 trillion.  This is more than M1 grew by over the 32 years between 1975 and 2007!  

This can also be seen on this graph which shows the annual percentage increase in M1:

Between 1976 and September 2008 when the Fed began to intervene to preempt the looming crisis, M1 grew by an average of 5.1 percent annually.  Since September 2008 when the crisis came to a head, M1 has grown by an average of 12.1 percent annually, more than twice the  average annual rate over the previous 32 years.

Now let's look at what has happened to M2, a broader money supply that includes M1 as well as what is termed "near money" which includes savings deposits, money market mutual funds and other term deposits that are less liquid but can still be converted into cash:

M2 has not risen as rapidly as M1.  Since the beginning of the Great Recession in December 2007, M2 has grown by $3.699 trillion or 49.8 percent to its current level of $11.128 trillion.

Here is a graph showing the annual percentage increase in M2:

Between 1981 and 2014, the growth rate of M2 averaged 5.98 percent.  Since September 2008, M2 growth has been somewhat higher at 6.7 percent, not a significant difference when compared to what happened to M1.   

Where has all of this money gone?  Generally speaking, the rate of growth in the money supply has tracked the rate of growth of the economy.  Here is a graph showing the difference between the annual growth rate of M1 and the annual GDP growth rate since 1975:

Between 1976 and the middle of 2008, GDP outgrew M1 money supply by an average of 1.8 percentage points annually (i.e. the annual growth rate of M1 was smaller than the annual growth rate of GDP).  Since mid-2008, this relationship has changed.  Between mid-2008 and the third quarter of 2013, the annual growth rate in M1 has outstripped annual GDP growth by an average of 9.3 percentage points annually, hitting a high of 19.9 percent in the first quarter of 2009.

Now, here is a graph showing the difference between the annual growth rate of M2 and the annual GDP growth rate:

Between 1982 and the middle of 2008, GDP outgrew M2 money supply by a rather slim 0.08 percentage points meaning that the annual growth rate of the economy very closely tracked the annual growth rate in M2.  Such is no longer the case.  Since mid-2008, the annual growth rate in M2 has outstripped annual GDP growth by a substantial 4.2 percent annually, hitting a peak of 12.3 percent in the first quarter of 2009.

While the Fed has been busy dumping record amounts of money into the system through its multifaceted, non-conventional policies, the economy simply has not responded as it has in the past, a problem that can quite clearly be seen when one looks at the record-low levels of the velocity of M2 as seen here:

Some talking heads think that nominal GDP growth will catch up to the growth levels in the money supply, returning the relationship between the two to historical norms.  Unfortunately, if GDP grows by the amount that it will have to in order to "catch up" to the recent growth levels of the supply of money, it will lead to two things; inflationary pressures and much higher interest rates than we are seeing now.  That will act to cut consumer spending and punish governments for their flagrant disregard for fiscal prudence during this period of near-zero interest rates. If, on the other hand, the Fed cuts the growth rate of the supply of money (i.e. tapering), that too will lead to higher interest rates.  Either scenario is not particularly encouraging.

As I said at the beginning of this posting, we certainly live in economically unusual times.  Only time will tell us whether the Fed's Grand Monetary Experiment was a success or a very painful failure.