Interpreting the Recent Behavior of the Monetary Aggregates

All research seems to indicate that, over time and everywhere, inflation is a monetary phenomenon. If this is true then we need to take some account of monetary aggregates in the short run so as to better understand what is taking place and what the current situation implies for the future. Also, it seems as if interest in the monetary aggregates might be surfacing once again. (See my post, http://seekingalpha.com/article/217598-monetary-targets-a-fresh-take.)

Let’s look at the current situation beginning with the quarter that followed the start of the Great Recession, the first quarter of 2008. If one looks at the year-over-year growth rate of the M2 measure of the money stock, things look relatively benign. Growth remained modestly above 6% through the first nine months of

the recession, but rose to over 10% by early 2009. However, this did not signal that monetary policy was working even though the end of the recession has been dated as July 2009. In fact, in looking at all the other monetary measures one could discern some troubling behavior that might indicate a deeper recession and a very slow recovery.

For example, the behavior of this measure certainly did not track the performance of bank reserves or the monetary base. Through the first nine months of 2008, total reserves in the banking system averaged a little under 5%, year-over-year. In the second quarter of 2009, the rate of increase was over 1,800%! The monetary base performed in a similar fashion. For the first nine months of 2008, the monetary base grew around 2.5% year-over-year. This increased to more than 100% in the beginning of 2009.

Of course, we know the reason why these reserve aggregates grew so rapidly while the money stock measure picked up only modestly. Excess reserves in the banking system went from less than $2 billion in the second quarter of 2008 to over $800 billion in the first quarter of 2009. The Federal Reserve was supplying funds to the banking system. However, the banking system was just holding onto them!

There was another movement within the monetary aggregates that was also of interest during this time period. The growth of required reserves, the reserves the banks had to hold behind their deposits, rose throughout 2008 but not nearly at the pace of total reserves or the monetary base. Note, however, that the growth rate of the non-M1 component of M2 remained relatively constant throughout 2008 and 2009 which indicated that a lot must be happening within the M1 measure of the money stock.

Here we see that through the first six months of 2008, the M1 money stock hardly grew at all. However, starting in September 2008 which marked the beginning of the financial crisis, this measure took off and was growing by almost 17% in early 2009. Growth was mainly in the demand deposit component of M1.

Two things were happening here. First, interest rates fell dramatically in 2009; keeping money in interest bearing accounts at banks and thrift institutions did not make much sense. Second, as people lost jobs and the economic environment became more and more uncertain, people and businesses moved assets from less liquid vehicles to transaction balances (demand deposits and other checkable deposits) so as to be able to buy necessities and to pay bills.

It is very important to identify this behavior because it explains a lot about how people were using their wealth at this time and what kinds of pressures they were feeling. This information helps us understand why the economy is performing the way it is and what implications this kind of behavior has for the future.

Taking this analysis into 2010 we see that the growth rate of M2 drops off drastically to less than 2%, yet M1 continued to incease at rates in excess of 5%. This is because people continued to transfer funds from interest-bearing accounts into transaction accounts. This is supported by the information on the growth rate in required reserves which was still above 10%. Note, that because of this the Federal Reserve has needed to continue to supply more reserves into the banking system to handle this increase in required reserves yet maintain the extraordinarly high levels of excess reserves in the banking system, reaching more than $1.0 trillion in the fourth quarter of 2009.

What this indicates to me is that the behavior of people and of the business community has not changed much over the past two and one-half years. People are still scared. Because of the tepid economy, high unemployment, and the uncertainty about the future, economic units still prefer to put their funds into transaction accounts so that they can facilitate their needed expenditures. This kind of information does not give one much confidence.

Furthermore, this kind of behavior is not what is seen before economic recoveries pick up steam. And, with the M2 measure of the money stock growing below 2%, year-over-year, one can only conclude that money is not entering the economy in a way that will stimulate future business expansion. Only when bank loans begin to increase and, consequently, M2 begins to expand more rapidly, then, maybe, confidence in the recovery will grow.

To me, monetary information is very valuable in trying to understand what is happening in the economy and where the economy might be going. However, the analysis of monetary aggregates must not be the kind of “cookie-cutter” analysis done in the 1970s and 1980s. Good analysis of the monetary aggregates is very complex and must include some historical analysis with it.

Watching the Money Flow

There are signs here and there that the economy is gathering strength. Note especially the figures on industrial production and capacity utilization. Although we have not returned to the levels reached earlier, the movement in these measures is definitely up.



Unfortunately, we are not seeing this movement in the monetary statistics relating to individual and banking behavior. As has been reported in my posts bank credit extension continues to decline. And, the way people are handling their money does not indicate any change in how people are handling their assets.



For example, the year-over-year rates of increase in the various measures of the money stock indicate that people are still holding a great deal of their assets in transaction accounts in banks and continue to keep as liquid as they can. This kind of behavior is defensive in nature and can be interpreted as showing that the public remains so uncertain about the future that they want to be prepared for contingencies, like becoming unemployed.



As mentioned in an earlier post (http://seekingalpha.com/article/188703-keep-your-eye-on-the-money-flow), the public began moving large parts of their wealth into cash and transactions in the latter part of 2007 and into 2008. We can see this movement in the change in year-over-year growth rates in the M1 and M2 measures of the money stock. The M1 measure began to accelerate in early 2008 and the M2 measure began to grow more rapidly in the first part of 2009. Looking further into 2009 and 2010, however, we see that M1 money stock growth has remained relatively strong whereas M2 money stock growth tapered off substantially.

Two points can be made: first, the Federal Reserve was pumping reserves into the banking system throughout this period, yet given the performance of the banking system and the M2 measure of the money stock it is obvious that this injection in reserves did not account for the changes in money stock growth. The behavior of the banks and the public lead one to refer to this as a liquidity trap as banks piled up excess reserves during the time period to the total of about $1.2 trillion.

Second, and perhaps more convincing, there is evidence of massive shifts of funds from less liquid assets to the most liquid of financial assets throughout this time period. For example, in September 2009, the year-over-year decline in small denomination time and savings accounts at commercial banks and thrift institutions was about 5%. In February 2010, these accounts were declining by more than 21%, year-over-year. Retail money funds were declining at about a 16% rate last September; now, they are declining by more than 26% year-over-year. Institutional money funds are declining in February at almost 16% year-over-year whereas they were increasing last September.



The point of this is that people are moving these assets into accounts that are transaction accounts, like demand deposits and money market or checkable deposits. Most of these accounts are counted in the M1 measure of the money stock and not in the non-M1 portion of the M2 money stock. This is the reason for the divergence in the growth rates of the two measures of the money stock.



For example, demand deposits at commercial banks rose by more than 14%, year-over-year, in February. This is down from about 20% in September. Other checkable deposits at commercial banks rose by around 19% in February, up from about 16% in September. And, savings deposits (which include money market deposit accounts), at both commercial banks and thrift institutions rose by about 14.5% in both February 2010 and September 2009.



The conclusion: people are still scared about their future and continue to act in a very protective way. There is little or no borrowing going on, at least, not enough to cause the lending totals at commercial banks to rise. One can certainly argue that the lack of bank lending is due to a lack of demand as well as the unwillingness of banks to lend.



Furthermore, money stock growth has not come from Federal Reserve initiatives to expand the bank lending. The growth being experienced by both measures of the money stock are coming from people re-arranging their asset portfolios and not from monetary policy.



The big unknown still remains the Federal Reserve and its “exit” policy. If and when people begin to borrow again and begin to spend again, bank credit extension should start to accelerate. This will lead to real money stock growth. The question is, how will the “undoing” of the Fed impact this loan growth and any subsequent monetary growth. Obviously, if too many of the excess reserves previously pumped into the banking system by the Fed gets into the various measures of the money stock, there could be some serious long run inflationary problems.



Consequently, it is necessary to continue to watch these money numbers to see what people and the banks are doing.

A Look At The Monetary Aggregates

The growth of the monetary aggregates has slowed significantly in recent months. This, of course, does not mean that the significant concerns over the $1.0 trillion in excess reserves in the banking system have evaporated. By no means!

Looking at the monetary aggregates does provide us with vital information about what economic units are doing with their assets. We took a look at this in an earlier post last November: http://seekingalpha.com/article/175766-how-people-are-using-their-money-and-what-it-says-about-the-economy. At that earlier time, it was obvious that people were moving their assets into transaction accounts and shorter maturity deposits. Also, people were moving money from thrift institutions into commercial banks.

This general movement of wealth can be called “bearish”. That is, when people lack confidence in the economy and in the future, they move into cash and other very liquid assets.

The December year-over-year rate of increase of the currency held outside the banking system stands at 5.7%. This is right in line with the growth rate of M1, the narrow measure of the money stock, which was 5.9% in December.

These growth rates are the lowest to be achieved in 2009. As I shall argue, this is not a sign that “bearishness” is over, just that it lessened throughout the year.

The August year-over-year growth rate for currency was 10.5% and for October 8.3%. The similar measures for the M1 measure of the money stock were 18.5% and 13.4%, respectively. Thus, the move into these assets have slowed, measurably.

There is still strong information that economic units are moving funds from time and savings accounts into transaction accounts. The December year-over-year growth rate of non-M1 accounts, primarily time and savings deposits, was 2.4%, substantially below the growth rate of Demand Deposits and other Checkable Deposits which stood at 6.3%.

The movement here also indicates that the movement from thrift institutions to commercial banks remained strong. For example, the year-over-year rate of growth of Thrift Deposits was 1.7% and this included an increase of Checkable Deposits at thrift institutions of 13.1%. The thrift industry is still really suffering.

Add to this the fact that the 1.7% figure includes deposits at Credit Unions, which are rising significantly, strengthens the argument that the traditional thrift industry continues to suffer badly!

Additional evidence of the move into very liquid assets is the fact that the amount of money placed in Retail Money Funds dropped almost 26%, year-over-year, and the money placed in Institutional Money Funds fell by 8.0%, year-over-year.

People continue to be afraid of the future, and, as a consequence they remain very bearish in terms of how they are managing their assets.

This leads to the conclusion that the basic positive movements in financial markets, in the stock market and in the bond market, almost all come from institutional trading. And, this “good” performance is coming from the interest rate subsidy that the Federal Reserve is providing to the banking system and the financial markets.

The increase in transaction accounts in the banking system has meant that the required reserves of the banking system have increased. The December year-over-year rate of increase of required reserves in the banking system was 18.5%.

To cover this, the Federal Reserve, continuing to err on the side of providing too many reserves, increased the monetary base by 22.0% over the same period of time. As a result, excess reserves rose by 40%.

The banking system still tells us a lot about what is happening within the economy. It tells us what the banks, themselves, are doing. It tells us how people are allocating their assets. It provides us with a gauge about the bullishness or bearishness of economic units. It also gives us some information on how the different sectors of the banking industry, big banks, small- and medium-sized banks, and thrift institutions are doing.

The scorecard:

• People are still moving their money from savings accounts to transaction accounts;
• Commercial banks, in general, are not lending;
• Economic units are, by-and-large, still very bearish;
• Big banks are doing very, very well;
• Small- and medium-sized banks are still on the edge;
• And, thrift institutions are really suffering.

One doesn’t see much of a recovery captured in these results.