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Minyan Mailbag: Money Supply

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next column with that very intent.

John,

The true definition of inflation which you elaborated on recently is helpful in determining what is a symptom (higher prices) and what is the actual cause of the disease (too much money).

You also have pointed out that the Fed can (and I think you believe actually is) increase liquidity even while raising the Fed Funds rate.

Recent data shows that regardless of which measure of money you choose (M2, MZM, or M3) that the increase in the supply of money is slowing dramatically. In fact the MZM's growth for the last year of 1.1% is the lowest since 1995 and has been steeply decelerating for the last year (since the tightening began).

Is this data incongruent with your beliefs or observations?

Minyan Joe

Joe,

If you look at short periods of time, the growth rate in the supply of money is not really slowing down; over longer periods it is. This is consistent with an economy hooked on credit. Let's examine what this really means.

The Federal Reserve can increase the supply of money by lowering rates so that banks can lend more money. This is the key. Banks must lend out the money. As an economy accumulates more debt, banks become more reticent to lend out marginal dollars as marginal rates drop. I have spoken about this before: the Fed can lower rates to zero, but if banks don't lend out the money the money supply will not increase. This is what I think we are seeing. If consumers have too much debt, new loans will slow despite lower rates.

The primary way I think the Fed is currently getting money into the system is by monetizing: they are buying longer term bonds with printed money in order to keep long rates stable. This has flattened the yield curve, and I think it will flatten it further. This does not show up in the money supply.

Another way the Fed strategically increases the money stock is through coupon-passes: they create dollars out of thin air and buy bonds from dealers. If the Fed did $1 billion in coupon passes with dealers, they would expect those dealers to lend out that money and through the multiplier effect anticipate a $10 billion increase in the supply of money. If the dealers do not lend that money out, the increase in the money supply will only be $1 billion. So again, in order for the Fed to significantly increase the supply of money they need cooperation from the system: banks must be willing to lend it and consumers must be willing to borrow it.

I look at the lackluster numbers you sight not as the Fed not providing liquidity, I look at it as the economy not cooperating because of an increase in risk aversion due to too much debt.

This is what Scott is showing as a bearish signal: investors and consumers decreasing their appetite for risk.

You can lead a horse to water, but you can't make him drink.

Regards,
Prof. Succo

No positions in stocks mentioned.

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