Monetary Watch September 2010, QE II when not if
The Austrian take on where we are on the monetary inflation front and what’s next…
Where We Are
The money supply aggregates based on the Austrian definition of the money supply (TMS) surged in August, with broad TMS2, THE CONTRARIAN TAKE’s preferred money supply metric, up an annualized 9.5%. The more important year over year growth rate on TMS2 was once again sporting a double digit rate, posting a rate of 10.7% in August, up from July’s 10.3% rate. This makes the 20th consecutive month that TMS2 has posted double digit year over year growth, a cumulative increase of 19% over those 20 months. To put those figures into perspective, the run-up to the now infamous housing bubble turn credit implosion turn Great Recession saw a string of 36 months of double digit growth for a cumulative increase of 48%. So yes, today’s inflationary largesse may be only 40% of that which brought on the Great Recession, but this one’s still in process.
As has been the case throughout 2010, M2, the mainstream’s favorite monetary aggregate, continues to show anemic growth, in July posting a year over year growth of just 2.7%. As readers of this column are aware, in the opinion of THE CONTRARIAN TAKE, M2 is a grossly misleading measure of the money supply, meaning the gap between the true and the perceived rate of monetary inflation is a hefty 8 percentage points.
Combine this anemic rate of monetary inflation as measured by M2 with the widespread aghast over historically low “core” rates of price inflation as measured by mainstream price level aggregates such as CPI, PPI and PCE and, contrary to the facts, you can see why deflationary concerns are currently all the rage.
To an Austrian though, inflation is the increase in the supply of money. One of its consequences, though not nearly the most important, is the lagged impact an increase in the supply of money has on the general level of goods and services prices. Indeed, far more important are the distortions and dislocations such monetary largesse wrecks on the economy and financial markets – in Austrian terms, the boom turn inevitable bust – the latest one being the housing bubble turn credit implosion turn Great Recession.
So, to the FOMC and mainstream economists and investors alike, deflation remains right around the corner. To an Austrian, inflation is alive and well.
A Look at TMS2 Internals
In THE CONTRARIAN TAKE’s August Monetary Watch, we had a look at the source of today’s monetary inflation, making the case that it’s the Federal Reserve via the issuance of base money, namely currency plus bank reserves (the bulk of which springs directly from the Federal Reserve’s power to monetize assets by writing checks on itself), that has provided the majority of the monetary largesse over the past 2 years. Private banks, historically responsible for the lion’s share of inflation via the issuance of uncovered money substitutes (which springs from the ability of those banks to pyramid deposits on top of base money when making loans or purchasing assets), have largely stood aside.
Well, recent trends suggest that while private banks may not yet be ready to reassert their more dominant role in the monetary inflation process, they are certainly beginning to make a contribution. Uncovered money substitutes increased an annualized 13.4% in August and are now up 8.6% annualized over the last three months and 8.3% over the last twelve. There relative size in TMS2 is shown below:
Note the recent trend, with uncovered money substitutes rising from a low of 68% of TMS2 in February to August’s 71%.
To repeat, this is not to say that private banks are about to turn on the monetary spigots and let it rip. Indeed, while bank loan and investment aggregates have seen some life of late, recent trends in the credit aggregates suggest that the growth in uncovered money substitutes is more the result of depositors liquidating time deposits and other term bank deposits in favor of instantly redeemable demand deposits, other checkable deposits and savings accounts. In Austrian speak, bank creditors are liquidating credit claims, raising cash, then depositing and holding that cash in money substitute form with those same banks.
That said, if in fact these currently risk averse private banks, that sit on top of $1 trillion plus in reserves, are ready to multiply those reserves into credit and deposits, that plus another round of quantitative easing could create one heck of an inflation party, possibly to the tune of trillions of dollars. Certainly no guarantee, but something clearly worth watching, especially if a deflation wary Federal Reserve is prepared to give the banks a bit of a “push.” Say, by reducing the rate it pays those banks on their excess reserves? As discussed below, not mere speculation, but by the Federal Reserve’s own admission something that could very well be at hand.
In a word, QE II.
Let’s begin with Chairman Bernanke’s speech at Jackson Hole on August 27th:
… the pace of recovery in output and employment has slowed somewhat in recent months, in part because of slower-than-expected growth in consumer spending, as well as continued weakness in residential and nonresidential construction. Despite this recent slowing, however, it is reasonable to expect some pickup in growth in 2011 and in subsequent years… And as the expansion strengthens, firms should become more willing to hire. Inflation should remain subdued for some time, with low risks of either a significant increase or decrease from current levels.
Although what I have just described is, I believe, the most plausible outcome, macroeconomic projections are inherently uncertain, and the economy remains vulnerable to unexpected developments. The Federal Reserve is already supporting the economic recovery by maintaining an extraordinarily accommodative monetary policy, using multiple tools. Should further action prove necessary, policy options are available to provide additional stimulus…
Indeed, as Chairman Bernanke continually reminds us, the Federal Reserve is compelled to provide that stimulus, for it is not only charged with providing stable prices but with promoting economic growth and full employment. And as luck would have it, it appears, at least in Bernanke’s mind, that the current setup for that said stimulus couldn’t be better:
First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.
Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.
In other words, if the economy continues to weaken, Bernanke will be a man on a mission. With price inflation expected to be of no concern, its Katy bar the door – the Federal Reserve will be free to roll out whatever tools necessary to pump the money supply and save the economy.
So, what are those tools? Back to Bernanke’s Jackson Hole speech:
Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus. I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves.
The first tool – conducting additional purchases of longer-term securities means another round of asset monetization, another round of base money and therefore a guaranteed dollar for dollar expansion in the money supply.
The second tool – modifying the Committee’s communication is simply, when all is said it done, the FOMC telling the market it plans on implementing the first tool – asset monetization – whenever and for however long it deems appropriate.
The third and final tool - reducing the interest paid on excess reserves, that’s the mother load, and “liquidity trap” concerns notwithstanding, perhaps all that is needed to push private banks into liquidating their $1 trillion plus reserve stash and pyramiding up the money supply through a multiple expansion of loans and investments. You see, if private banks, the same banks that have been hoarding reserves in fear of their solvency (at 25 bps, 15bps over one-month Treasuries and about the same as one-year Treasuries, thank you very much), choose not to impair their liquidity position by making risky loans or purchasing risky assets, or if private borrowers, those same borrowers many of whom are currently up to their necks in debt, choose not to borrow, there’s always that swelling supply of “super safe” U.S. Treasury and agency securities to fill the bill. For the U.S. government is currently more than willing to be both the borrower and spender of first and last resort. And what better way to push banks in that direction than to pay little to nothing on excess reserves.
So there’s the QE II playbook. The only questions remaining are – if and when.
Well, in the opinion of THE CONTRARIAN TAKE, there is no if. It’s simply a matter of when. Here’s why…
To an Austrian, easy money and managed interest rates are the source of, not the solution to the things Chairman Bernanke fears most – a weak economy, high rate of unemployment and yes, even deflation. Such monetary interventions in the economy always and everywhere create artificial booms, bubbles in popular parlance, with their inevitable consequence always and everywhere being busts – credit crises, recessions and depressions. You see, by artificially lowering interest rates and creating money and credit out of thin air, a central bank, aided and embedded by its too big too fail private bank partners, create economic and financial distortions – malinvestments, which eventually must be liquidated. And once the central bank ceases its easy money policies, by halting the further issuance of money and money substitutes, or even slowing its rate of increase, the boom soon comes to an end and the bust ensues. Sooner or later, free market forces prevail. Sooner or later, the central bank induced boom REQUIRES a bust.
So then, what has Chairman Bernanke given us, so far? Double digit money supply growth and zero interest rates, right. He’s given us a boom (an anemic one at that) that at some point MUST give us a bust. Combine this certainty with the repeal of the Bush tax cuts, the likely crippling impact of Obamacare and Fin Reg, and what seems a never ending parade of intrusive government programs as far as the eye can see, all against a still debt-laden private sector, and it’s easy to see why the economy is in a heap of trouble.
And in time, and by extension, it’s equally easy to see the near certain implementation of Bernanke’s QE II tool set.
Now, while a 10.7% year over year rate of growth in TMS2 is highly inflationary, it is down from the high of 16.5% posted back in November of 2009. That fact plus the economically debilitating effects of the pending tax increases, as well as the plethora of forthcoming government interventions into the economy, suggest that our current anemic boom could very well be close to turning bust. And with that, it should go without saying that with Ben Bernanke at the helm of the Federal Reserve, another round of Federal Reserve engineered inflation could be right around the corner.
Based on the monetary insights of the Austrian school of economics, THE CONTRARIAN TAKE offers up the latest monthly money supply metrics for the U.S., Eurozone and Japan currency blocks.
To see the entire monthly series offering – the latest money supply data for all three currency blocks, with full historical data and chart work, as well as supporting definitions, sources, notes and references – click here on Austrian Money Supply.
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