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Broad money supply growth is a strong indicator of pending inflation. The current 15%-plus level of annual growth in an ongoing estimate of M3 -- the broadest measure of the U.S. money supply -- has not been seen since August 1971, when President Richard Nixon closed the gold window. Such foreshadows increasing monetary inflation pressure in the U.S. economy, on top of existing pressures from oil and food prices and a weakening U.S. dollar. In contrast, recent slow growth in the monetary base is not uncommon under current circumstances and does not foreshadow consumer goods deflation. In 25-plus years of econometric modeling and economic forecasting, I found the broadest measure of liquidity in the system tended to be the most meaningful in predicting future inflation, and, under certain circumstances, economic activity. In an earlier day, when M2 was the broadest money supply measure, it was established as a component in the government's once index of leading economic indicators (now published by the Conference Board), because of M2's recognized strong leading relationship to economic activity. The broadest measure tends to work, given its scope, and because is relatively free of distortions that can affect narrower measures (i.e., cash shifting between different types of accounts). Traditional money supply measures of recent years have included three levels of aggregation: M1, which generally includes cash and demand deposits (checking accounts); M2, which generally includes M1 plus savings accounts, small time deposits (certificates of deposit less than $100,000) and retail money funds; M3, which generally includes M2 plus large time deposits (jumbo CDs of $100,000 or more), institutional money funds, repos and euro-dollar deposits. A relatively new measure, Money Zero Maturity (MZM), which is calculated by the St. Louis Federal Reserve, includes only cash accounts that have no maturity considerations, specifically M2 less small time deposits plus institutional money funds. At the narrow end of the spectrum is the monetary base, which generally is bank reserves plus currency (an M1 component). Back in March 2006, the Federal Reserve ceased reporting of M3, claiming lack of relevance and bemoaning the excessive cost in producing the series. The reasons given for killing the series appeared to be nonsensical. How could small time deposits in M2 be relevant, but not the large time deposits in M3? How could retail money funds in M2 be relevant but not institutional money funds in M3? Those two M3 components alone total roughly $4 trillion at present. Separately, the Fed has continued to incur the cost of tracking much of the information used to calculate M3. Personally, I believe the Fed did not want the markets to see a pending surge in broad money growth that would add to already mounting inflationary concerns and expectations. Where cash would shift out of M2 into large time deposits and institutional money funds, such would depress M2 growth artificially, while M3 would show the full picture. That partially is what has happened, and therein is part of the benefit of looking at the broadest money measure, as can be seen in the accompanying graph of M3, MZM and M2. At the request of subscribers, Shadow Government Statistics began estimating ongoing annual growth in M3, which has generated the non-official data shown in the accompanying table and graphs.
As the recent banking solvency crisis broke, the Federal Reserve lent money to banks, as needed, and pumped and continues to pump liquidity into the system. Annual growth in the seasonally adjusted the monetary base (Federal Reserve series), which includes bank reserves and the M1 currency component, however, did not surge, showing growth in excess of 2.0% in recent months, slowing to 1.5% in December, with the bulk of that growth coming from an unreliable currency number. The currency measure is unreliable because the Fed has no accurate tally of how much currency (perhaps up to two-thirds) is outside the United States .Bank reserves were little changed over the year. So, how can annual M3 growth be at 15.2% with the monetary base showing annual growth of just 1.5%? The answer lies in a number of factors, including liquidity flowing into the United States from outside the system, the impact of which is within the Fed's control. The Fed has opted for systemic liquefaction. First for clarification of some relationships, historically, there is a negligible correlation between monthly annual growth of the monetary base and M3 (-14% for 1970 to 2007). A relatively high M3 growth versus low-growth monetary base, though, has been common to most recessions seen since 1970 (1990/1991excepted). The monetary base does have a fairly strong correlation with M1 (68% for 1970 to 2007), but M1 has been in year-to-year contraction since mid-2006, as shown in the accompanying graph of M1 and the monetary base, and also has little predictive value related to inflation.
Again, where the broadest measure available always has been the best predictor of inflation, the relative size and annual growth rates of the various money measures are indicated in the following table, as of December 2007. Some Comparative Money Numbers Measure $Billion Yr/Yr SGS-Alternate M3 12,927 +15.2% The strong growth in M3 partly reflects still-growing foreign investment in U.S. Treasury securities. The Federal Reserve has control over the nation's money supply. In terms of spiking broad money growth, the U.S. central bank can take action to inject funds directly into the system, or it can do so on the behalf of others, or sit passively by as others act. By not sterilizing or offsetting the impact of foreign held dollars going into U.S. Treasuries or Agencies, the Fed is setting a policy of inflating money growth just as much as if it were injecting the funds itself. The Fed also has the option of changing reserve requirements, which, at present, enable a deposit of $1,000 to translate into $10,000 after successive relending of the funds that do not have to be held in reserve. As noted in off-balance sheet items in the Fed's Factors Affecting Reserve Balances of Depository Institutions (H.4.1 of January 10, 2008), Treasuries and Agencies held by the Fed for other central banks stood at $2.057 trillion for the week ended January 9, 2008, up by $287.0 billion, or 16.2%, from January 10, 2007. That represents a significant influx of liquidity into the U.S. monetary system. As mentioned earlier, also at work in the broader money measures has been cash flowing out of M2 accounts to M3 accounts, such as large time deposits and institutional money funds. In the absence of official M3 reporting, the increasingly popular MZM measure also has shown a rapid pick-up in annual growth, thanks particularly to growth in institutional money funds. Having used broad money growth in economic forecasting, I have found that solid M3 growth signals strong economic growth some of the time, but often times it does not. Adjusted for inflation, however, M3 growth slowing sharply to the downside, as did happen in the last two years, is a reliable leading indicator of an economic contraction. On the inflation front, double-digit broad money growth usually is followed within a year or two by double-digit increases in consumer costs. Inflation, as used here, means price increases as seen in consumer goods and services. Of course, the prior events in the 1970s and early 1980s were before many of the methodological changes to the CPI that have resulted in current, regular understatement of CPI inflation. The inflation currently signaled by M3 is not for financial asset inflation, such as in the equity markets. From the standpoint of financial assets, a very short-term leading indicator has tended to be M1, which currently is in annual contraction. The present money supply growth levels are consistent with a deteriorating inflationary recession, which only recently has started to gain broad public recognition. One of my best bets is that inflation will continue to get worse, not better, despite an accelerating downturn in economic activity and widening solvency issues for major financial services firms. Regardless of how much pressure is placed on the financial and banking systems, the Fed will do everything in its power to prevent a 1930s-style collapse in the system and money supply. Federal Reserve Chairman Bernanke is a student of that period and has indicated he would liquefy the system as much as needed. While the Fed has the power to that -- and it appears already to be doing so -- the ultimate cost will be in higher U.S. inflation and a debased U.S. dollar.
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