Plunging Inflation-Adjusted Annual M3 Change Generates Intensified Signal of Renewed Economic Downturn. Commentary No. 268 of December 30, 2009 discussed the leading relationship between real (inflation-adjusted) year-to-year contractions in the broad money supply (M3 and the SGS-Ongoing M3) and the economy, and a signal for a double-dip downturn. In modern economic history, every time there has been such a year-to-year liquidity contraction, the economy subsequently has turned down, or if already in recession, the economic downturn has intensified. A signal for such an intensification of economic contraction was generated in November and December, and the signal got significantly stronger in January.

The above graph of year-to-year change in real M3 versus year-to-year change in payroll employment, updates the one shown in Commentary No. 268 in several areas. First, the plot of M3 has been shifted six months into the future so as better to show the correlation between annual real M3 contractions and annual payroll-employment contractions. Accordingly, the point for January 2010 M3 growth is plotted over the timeline on the axis for July 2010. Second, the graph incorporates subsequent benchmark revisions to both the money supply and payroll data. Third, it includes January estimates, (January 2010 real M3 fell an estimated 5.2% versus January 2009, following an annual contraction of 3.3% in December 2009 and 0.3% in November. The January 2010 number is based on a conservative estimate of annual 2.6% CPI-U inflation in January.

Not-So-Happy Implications. This particular signal on looming economic activity rarely is seen, but once it is generated, it is solid. The weaker economy ahead will be particularly disruptive to a system that assumes positive economic growth will be seen in all of 2010.

Consider that the Administration’s latest budget deficit projections are based on an assumed 3.0% year-to-year (fourth quarter) and a 2.7% annual-average real GDP growth rate in 2010. Reality should be a 2010 GDP contraction, and there is nothing in play to support significant if any GDP expansion in 2011. Not only will federal and state tax revenues fall well short of expectations, but also increased support for failing economic and financial infrastructure and likely financial bailouts for some states will balloon the federal deficit — and corresponding Treasury funding needs — well beyond consensus estimates and credit market tolerance.

Consider too that projections of recovery and stability within the U.S. banking system are dependent on positive economic growth in the year ahead.  

Global Implications. The economic and systemic-solvency problems in the United States remain severe in scope and depth. The U.S. difficulties also are much worse than those of its main trading partners, and the eventual recognition of same should have negative impact on the U.S. dollar’s exchange rate versus most major currencies. A significant break in the dollar also should begin to disrupt the abnormal relationship seen currently between the various financial markets in the United States, where a weak dollar is countered by strong stock prices and vice versa. A weak U.S. economy and faltering fiscal conditions should result in U.S. dollar weakness, which in turn should be reflected in tightening domestic liquidity, higher interest rates and a lower equity prices. In such a circumstance, the dollar’s intensified weakness also should be reflected in mounting inflation pressures and much higher gold and silver prices.

The timing on this is open, but I would be surprised if the recognition of the onset of a largely unexpected new major dip in a double- or multiple-dip economic downturn does not roil the markets significantly in the year ahead. The renewed economic weakness should become increasingly evident in the next couple of months. More will follow.

Money Supply Contraction Intensifies. Based on more than three weeks of data reported for January, the preliminary estimate of seasonally-adjusted year-to-year change in the January 2010 SGS-Ongoing M3 is a nominal contraction of 2.6%, following a 0.6% annual contraction in December. Month-to-month change was roughly a 0.9% contraction in January, following a 0.4% decline in December.

Year-to-year change in M2 is estimated at a 1.9% gain in January — a contraction after inflation adjustment — following a 3.4% annual gain in December. Month-to-month, January M2 dropped about 0.8%, following a 0.2% gain in December. Year-to-year change in M1 is estimated at a 6.3% gain in January, a notch higher than the 6.2% annual reported gain for December. Month-to-month, January M1 fell by roughly 1.2%, following a 0.4% gain in December.

Monetary Base Resurgent. The Fed again is pushing the monetary base higher. With slowing growth in M2 (the broadest money measure published by the Fed) and continued credit contraction, the Fed has to know that conditions are not healthy or appropriate for economic expansion. These conditions also are suggestive of ongoing difficulties in the U.S. banking system. Continuing to act as though such were the case, the Fed pushed the St. Louis Fed’s Adjusted Monetary Base measure to $2.059 trillion in the two weeks ended January 27th — its second highest level ever — 1.0% shy of the December 2, 2009 period peak and up at an annualized 56.1% rate of growth since the near-term trough in the August 12, 2009 period.   

The monetary base is currency in circulation plus bank reserves. At present, banks are leaving extreme levels of excess reserves on deposit with the Fed, instead of lending those funds into the normal stream of commerce.

Week Ahead. The following text is not changed from the prior Commentary No. 276 except for an updated consensus estimate on retail sales. Given the underlying reality of a weaker economy (and likely re-intensifying downturn in the coming months) and a more serious inflation problems than generally are expected by the financial markets, risks to reporting will tend towards higher-than-expected inflation and weaker-than-expected economic reporting in the months ahead. Such is true especially for economic reporting net of prior-period revisions. 

Trade Balance, Goods and Services (December 2009). The December trade deficit is due for release on Wednesday, February 10th. Briefing.com shows a consensus estimate for some narrowing of the monthly deficit, and such would be necessary to prevent a downside revision to the initial estimate of 5.7% annualized real (inflation-adjusted) growth in fourth-quarter GDP. My betting is for some further deterioration in the deficit, which would knock a little growth off the estimated GDP, due for revision at the end of this month. The reported fourth-quarter "improvement" in trade guesstimated by the Bureau of Economic Analysis added 0.5 percentage points to the quarterly GDP growth rate.

Retail Sales (January 2010). Due for release on Thursday, February 11th, January’s monthly retail sales are expected to show a 0.5% (up from 0.4% last week) monthly gain, following a 0.3% contraction in December (per Briefing.com). Reporting risk is to the downside, and inflation-adjusted growth likely will be flat-to-minus on both a month-to-month and year-to-year basis.

Heads Up: 2009 GAAP-Based Financial Statements of the U.S. Government. The Treasury’s Financial Management Service advises that the GAAP statements are scheduled for release on Tuesday, February 16th. The statements were delayed, without explanation, from the regularly scheduled release date of December 15, 2009. A Reporting Focus Commentary will follow after I have had a chance to assess the report.