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Is the Fed Deflating?


No one can put a date on it, but what we do know is that credit bubbles end in deflation.


I received a record high number of emails last weekend asking me to comment on a recent article by Gary North. Following is one such request:

Mish, Gary North has an analysis that he e-mailed out today claiming that the Fed is actually deflating. I'd appreciate your comments on his article if your time permits.

The article in question is Bernanke Has Snookered Us All. Here is a very condensed extract:

Bernanke and the Federal Open Market Committee (FOMC) have done something extraordinary. They have publicly lowered the FedFunds target rate, and have forced down the actual FedFunds rate to meet the target rate, while deflating the money supply.

You read it here first: "deflating."

I am doing my best to stick with the available facts. These facts are not consistent with what I thought the FED would do, as recently as August 28. They are surely not consistent with what the hard-money camp is telling you the FED has been doing.

If your mother says she loves you, check it out.

Gary North

Gary makes his "deflating" claim by looking at changes in base money supply. Rather than copy the chart he presented, I will reproduce it from the same source so that additional charts in this article all have the same look and feel. I am also going to add a few comments to some of the charts.

Monetary Base Seasonally Adjusted 2006-07-01 To 2007-09-21
Chart as North presented (my comments in red)

Click here to enlarge.

I do not see much of anything in that chart so let's look at year over year percentage changes.

Monetary Base YOY% changes 2006-07-01 To 2007-09-21
Seasonally Adjusted

Click here to enlarge.

As Gary points out "an increase of 1.8% is tight money policy by previous Fed standards" But 1.8% is still in positive territory. There is far more to it than that, however, which I will address in just a bit. But right now let's take a look at longer timeframes.

Monetary Base YOY% 1994-01-01 to 2007-09-21

Click here to enlarge.

The above chart speaks for itself. On the basis of base money supply (actual monetary printing) no claim can be made about rampant Fed printing. It just can't be done.

M2 1960-01-01 To 2007-09-21

Click here to enlarge.

No doubt some will point to M2 or M3 (many pointing out a conspiracy theory regarding the discontinuance of M3) that money supply is soaring.

The problem with using M2 or M3 as a measure of money is that both include credit transactions. I happen to agree with Gary that the distinction between money and credit is paramount.

I recently discussed this idea in Is the U.S. printing money like mad?

My own preferred monetary measure is called M Prime (see above article) but the closest approximation from readily available sources is M1. So let's take a look at M1.

M1 1980-01-01 To 2007-09-21 Seasonally Adjusted

Click here to enlarge.

M1 1980-01-01 To 2007-09-21 YOY % changes
Seasonally Adjusted

Click here to enlarge.

Gary had this to say in his article:

"I don't think my message has penetrated the thinking of most hard-money contrarians. They keep citing M-3, which was canceled by the Fed a year ago, and which was always the most misleading of all monetary statistics. Year after year, the M-3 statistic was four times higher than the CPI. The M-3 statistic was worthless from day one."

I agree wholeheartedly with the idea that M3 is a fatally flawed measure of monetary printing. It's also a very unreliable predictor of the CPI. But even if M3 (and credit/debt creation) is useless for many things, it cannot be totally ignored. With that thought in mind, let's explore the idea of how money is created.

How Money Is Created

Paul Grignon's video Money as Debt offers tremendous insight into how money is created (as long as one realizes it's not really money the author is talking about but rather a money substitute better known as debt). Please view the whole thing. It might open your eyes.

The first 3/4 or so of the video describes exactly what is happening but Grignon goes seriously astray by blaming a gold standard for past problems when the real culprit is fractional reserve lending. In the last 1/4 the author Grignon again goes off the deep end by proposing government intervention as the solution to the credit bubble when it is in fact government intervention that has created the mess we are in. Nonetheless, the video is likely to be a great eye opening experience for many that explains how credit is soaring while base money is relatively flat.

An Email From Gary North

One of the emails I received last weekend was from Gary North. He asked me if I could find any flaws in his analysis. What follows from here on down is my reply to Gary:

Gary, you are correct about many things:

  • The Fed is not massively printing as most claim.
  • As measured by M1, M Prime, or Base Money the Fed is actually tight.
  • M3 is a poor predictor of CPI inflation.
  • There is a huge difference between credit and money.

It is very easy to prove the statement "the Fed is not massively printing" but people believe what they want to believe. However, Fed policies have been such to enable super easy credit transactions to take place by holding interest rates too low too long. When interest rates are held too low, asset bubbles build and credit/debt transactions soar. So does the velocity of money. But the Fed ignores these bubble (in fact even embraces them) as long as consumer prices are held in check.

Thus it's a serious mistake to look at base money, M1, or M' in isolation just as it is to look at M3 in isolation. One must also look at Fed policies to see whether interest rate polices foster enormous expansion of credit.

A rapid expansion of money supply tends to lead to outcomes as seen in the Weimar Republic or Zimbabwe, but a rapid expanse of credit is what we saw prior to the Great Depression.

But it's more complicated than that. To predict price stability, one also needs to look at what central bankers worldwide are doing. It is foolish to believe the Fed can directly control prices (and more importantly, wages) in a global economy where every day the U.S. is becoming less and less relevant.

The carry trade in Japan has also significantly distorted the world's economy. When will that unwind? The answer is no one really knows for sure. When it does bust, the impact will be stunning in significance and it likely won't be good for stock prices.

One cannot ignore the effects of psychology. In fact one has to start with psychology. It is confidence about the future (or pure desperation) that causes people to borrow and spend as opposed to save for a rainy day. We are starting to see changes in confidence now. I talked about confidence (sentiment) in Don't Worry, All Recessions Are Local.

A strong case can be made that the credit bubble is popping now, based on many changes in sentiment. Evidence can be found in canceled deals (see Buyout Bingo Reversal Continues), Northern Rock (see Crisis at Northern Rock Comes to a Head) and also in enormous disruptions in asset backed commercial paper (See Prof. Fil Zucchi's post Will Boom Boom Carpe Diem?)

In addition, one needs to consider the velocity of money. I talked about velocity, M1, and Japan in Inflation: What the heck is it?

If one uses M1 or base money as the sole measure of deflation, then we are indeed close. But if one believes that inflation/deflation is the expansion or contraction in money and credit, then as of now we are not close, "technically speaking". But that can change on a dime.

Housing sentiment changed overnight as did willingness to fund LBOs by Citigroup (C), Merrill (MER), Lehman (LEH), Bear Stearns (BSC), and Goldman Sachs (GS). Chuck Prince (Citigroup's CEO) went from being the belle of the ball to paying an exit premium to leave the ball prematurely.

We have seen rapid changes in psychology in housing, asset backed commercial paper, and LBOs. Consumer attitudes toward debt are changing as well. The trend change in the U.S. from consumption towards saving is coming.

I certainly thought this credit bubble would have ended by now. When it does happen, it will hit businesses like a brick wall. Many signs suggest the credit bubble is now popping but we have been down this path before only to have some other aspect keep the bubble inflating.

No one can put a date on it, but what we do know is that credit bubbles end in deflation. We also know the Fed will be powerless to stop deflation when it comes. The best explanations as to why can be found in Mr. Practical's missive on The Fed's Limitations, my Interview with Paul Kasriel, and Mr. Practical's article What Future Does the Credit Crunch Bring?

Economic and credit contraction are both coming as the inability to service debt spreads from housing, to commercial real estate, to consumer credit. At the leading edge of this tsunami is a massive change in debt psychology by all the key players. Those who ignore the warnings are likely to drown.

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