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. 

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.

The Slowing Velocity of Money - What Is It Telling Us?

July 2014

For your information, there is an up-to-date posting on the velocity of money located here.

There is a relatively little discussion about one particular parameter of the economy, the velocity of money.  As you will see in this posting, recent changes in the velocity of money may be a harbinger of things to come for the economy.

Let's start with a bit of background information and some definitions.  The velocity of money, according to the Federal Reserve, is a ratio of the nominal (before inflation adjustments) GDP to a given measure of the supply of money, either M1 or M2.  WTF?   

Here are a couple of definitions that might help.  First, M1 is the most liquid measure of the money supply and includes all physical money including coins and currency plus demand deposits (chequing accounts); basically money that is available immediately.  Second, M2 includes the aforementioned components of M1 plus money market funds, savings deposits and all time-related deposits.  

Now, let's go back to the velocity of money.  Putting Fedspeak into terms that mere mortals can understand, the velocity of money can be thought of as how often the money supply "turns over" or the number of times a single dollar is used to purchase the goods and services that comprise the GDP in a given period of time.  The velocity of money can also be thought of as the average frequency with which a unit of money is spent or how many times a given dollar bill is spent by all of the consumers that spend it as it works its way through the American economy in a given period of time.

Here's an example to make the concept easier to understand:

I earn $500.  I take that $500 and buy a plasma television from you.  In turn, you take the $500 and buy an iPad from someone else who then takes the $500 and buys a week's worth of groceries.  We have now turned over the original $500 three times and the result is $1500 of "GDP" and, since the $500 was spent three times, the velocity of the money is 3.0.  Stepping back to the entire economy, GDP is basically a function of the velocity of money; the more times a given dollar is spent, the faster the economy grows and the higher the resulting GDP.   When the velocity of money is high, the supply of money needed to keep the economy working is relatively low compared to periods where consumers are not spending as much and the velocity is very low.  If the value of money is low, prices are high and a larger supply of money is necessary to fund purchases.  If the supply of money is constant and prices are high, velocity must increase to fund purchases.  Similarly, when the supply of money is changed by the Federal Reserve, it will impact the velocity of money.  Basically, for a given level of GDP, a smaller money supply will result in increased velocity since each dollar must change hands more often to facilitate spending and vice versa.

Why would the velocity of money slow?  It can do so for a couple of reasons.  First, the velocity of money will slow in times of deflation when a contraction in the amount of money in circulation declines, resulting in lower prices.  Secondly, the velocity of money will slow during a recession as consumers decide to hold onto their cash rather than spend it on new televisions, cars, refrigerators and iPads. Thirdly, the velocity of money can slow because of the accumulation of debt in the economy.  This is most apparent in the accumulation of government debt; since one of the factors making up GDP is government spending as shown in this formula:

GDP = C + I + G + (X-M)

Where:

C = Consumer Spending

I = Gross Investment

G = Government Spending

X-M = Exports - Imports or Net Exports

Government spending or "G" is an important part of GDP meaning that growth in government spending is an important part of GDP growth.  Unfortunately, in today's reality, government spending grows through the use of increasing levels of debt, a factor that actually slows the velocity of money.  Just for fun, here's what total federal government spending has looked like over the past six decades, showing how its growth has become nearly exponential:

With GDP hovering around $15 trillion and federal government spending at roughly $3.75 trillion,  government spending makes up around 25 percent of GDP.  This tells us how massive the impact of reduced government spending will be on GDP growth.

Now, let's look at what has happened to the velocity of money over the past few decades and its relationship to recessions starting with M1 followed by M2.  Note that the velocity of M2 has dropped to lows not seen since the early 1960s.

Here is a look at the growth in M1:

Here is a look at the growth in M2:

Notice that the growth in M1, in particular, has become nearly exponential with a very steep growth rate in M2 as Mr. Bernanke had the Federal Reserve "printing presses" working overtime during and after the Great Recession.  

Now let's look at the velocity of money and the growth in the supply of money from Helicopter Ben in combination.  Basically, the Federal Reserve is pumping money into the economy but the velocity of money is dropping and approaching or passing fifty year lows.  This could suggest that the Fed's actions simply are not spurring economic activity despite recent growth in GDP (which could be a result of government spending increases).  Is it possible that the economy has entered a liquidity trap where nominal interest rates are basically zero and increasing the supply of money has no impact on the economy, rendering monetary policy by central banks completely ineffective?  In this state, low interest rates do not result in a state of full employment and consumers are not interested in consuming more.  As well, increased injections of money cannot push interest rates any lower since they are already basically zero.

At the very least, I would suggest that the rather dramatic drop in the velocity of money signals that there is looming change in the economy.  Only time will tell whether carnage or better times lie ahead.