July 5th, 2015
In past weeks I have been digging into a perplexing problem. Since early 2008, the Federal Reserve has heaped almost $4 trillion of government debt on its books and the supply of money has doubled, yet inflation remains subdued. Why?
There are several measures of money. For several decades the Federal Reserve branch published Modern Money Mechanics (book or PDF). M1 is a measure of transactional money, and includes cash and money held in checking accounts. This category of money has doubled in the past 7-1/2 years.
Supply of money goes up. Inflation goes up, right? From the Federal Reserve paper:
If inflation is not going up, then the output of goods and services must be going up as much as the supply of money, right? It’s not.
Some economists have argued that the various measures of money don’t measure demand for goods and services. Rather, the money supply measures uncertainty. Shown in the chart below is the annual percent change in both GDP and the M1 money supply.
The first thing we notice about the M1 chart above – when the growth in the money supply falls below zero, get worried. People are too confident in the future. It would be nice if we could craft a long term trading rule like “Buy stocks when the blue line crosses below the red line” but that has not been a successful strategy. What does stand out is that money growth, the blue line, crossed above GDP growth, the red line, in the summer of 2008 and has not crossed below. That is the longest period of time since this money measure began. Clearly, there is a lack of confidence among families and businesses.
In the quote from the Federal Reserve paper above, I passed over a key phrase that began the paragraph. Yes, very sneaky of me to do that. The phrase is “Assuming a constant rate of use.” I wanted to focus separately on the growth in the money supply and the growth in GDP. Economists often look at the rate of use of money to produce a given level of GDP. They call it the velocity of money. In the chart below, I have included the velocity of money, the ratio of GDP/MONEY (red line in the chart), and the amount of money in the system as a percentage of output, MONEY/GDP (blue line) to show how the two are mirror images of each other.
When economists worry that the velocity of money (red line) continues to fall during this recovery, they are worried that there is simply too much money sitting around for the amount of output in the economy (blue line). Why are people and businesses holding over 17% of output in readily available money today? We are in a low inflation, low growth economy. In the 1970s we held the same percentage of money but the ’70s was a high inflation, low growth economy. The similarity of then and now is low growth.
In these past weeks I have looked at two places to put savings – yesterday’s spending, debt, and tomorrow’s spending, equity. When people and businesses hold onto more money, which kind of spending are they investing in? They are concerned about tomorrow’s income. What does tomorrow’s income pay for? Both tomorrow’s AND yesterday’s spending.
Next week – if saving is just a form of spending, what is income?
Good job numbers. Not good labor participation numbers. Bill McBride at Calculated Risk did a good job this week of putting a long term perspective on the job numbers. Underscores the theme I just touched on. Low growth. For 12 years, from 2000 – 2012, there was almost NO job growth and the effect of that does not pass quickly as things improve. Caution prompts us to hold onto more money just to be on the safe side.