Flash Update
JOHN WILLIAMS’ SHADOW GOVERNMENT STATISTICS
FLASH UPDATE
January 13, 2008
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Recession Recognition Settles In
Moody’s Cautions on U.S. Credit Rating
December M3 Growth at 15.2%
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PLEASE NOTE: The SGS-Ongoing M3 series has been updated through December 2007, with details posted on the Alternate Data Series tab at www.shadowstats.com.
– John Williams
Recession Recognition. In the last week, not only did a number of Wall Street analysts jump on the recession band wagon, but also the Administration began talking of economic stimulus, and Mr. Bernanke appeared to cave in, effectively promising aggressive accommodation. If only the Administration and the Fed had viable options open to them, such as sound fiscal conditions that would allow for a tax cut or increased spending, or stable currency conditions that would allow significant rate cuts. Shy of the National Bureau of Economic Research (NBER) formally declaring a recession, this is about close as the system comes to acknowledging a recession at hand. Such a circumstance usually happens after a recession has been underway for six-to-nine months, or longer.
The general outlook for the year ahead remains in place: a deepening inflationary recession, a major bear stock market, heavy selling of the U.S. dollar, heavy buying of gold, and an eventual flight to safety away from the greenback that will spike long-term interest rates.
A Little Catch Up in the November Trade Deficit. In an otherwise quiet reporting week, the November trade report showed something of a surprise catch up in recent underreporting. Though still well shy of reality, the seasonally-adjusted trade deficit widened to $63.1 billion in November from $57.8 billion in October, reflecting rising oil prices.
Officially Gimmicked Federal Deficit Widens. In the first three months of fiscal 2008, surging outlays have widened the budget deficit to $105.5 billion versus $82.9 billion for the same period a year before. That puts the rolling 12-month deficit through December 2007 at $187.9 billion versus $211.8 billion in December 2006. The annual "improvement" in the deficit has narrowed to $24 billion in December from $49 billion in November and from $85 billion at fiscal year-end (September 30th).
A better estimate of the government’s operating cash shortfall is seen in increases to gross federal debt, which stood at $9.229 trillion at the end of December. That was up $80 billion for the month, up $222 billion for the quarter and up $549 billion from December 2006, which in turn was up $510 billion from December 2005. Updated analysis of the government’s 2007 GAAP-based financial statement will follow in the January SGS newsletter.
Moody’s Caution on U.S. Triple-A Rating. The SGS Primer on Federal Deficit Reality suggests that consistently applied rating standards (based on GAAP-based accounting of the U.S. fiscal condition) would relegate U.S. Treasuries to junk-bond status. Of some interest, the first signal for a possible ratings shift based on U.S. fiscal conditions was reported by Reuters on January 10th:
"Moody’s Investors Service said on Thursday the United States’ ‘triple-A’ government bond rating could come under pressure in the very long-term if the Medicare and Social Security programs are not reformed. ‘These two programs are the largest threats to the long-term financial health of the United States and to the government’s Aaa rating,’ Moody’s analyst Steven Hess said in the agency’s annual report on the United States."
M3 Growth Adds to Inflationary Pressures. Annual growth in December’s monthly average of the SGS-Ongoing M3 slowed to 15.2%, off its near-term peak of 15.7% in November, but still at a level that historically has been followed by heavy monetary inflation.
Due to continued subscriber questions, this section has been expanded to look more closely at some of the relationships between the various money measures and inflation, including some numbers updated from the December 2007 SGS newsletter. Part of the following commentary may appear in an article to be contributed for public consumption.
Growth of broad money supply in the U.S. financial system is a strong indicator of business activity and predictor of inflation. The current 15%-plus level of 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 pressures in the U.S. economy, on top of existing pressures from oil, food and a weakening U.S. dollar. In contrast, recent slow growth in the monetary base is not uncommon under the circumstances and does not foreshadow consumer goods deflation.
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 its strong relationship to economic activity. Generally, the broader the liquidity measure, the better is the predictive value of that measure.
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.
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 appear 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? Separately, the Fed 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 add to 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 subscriber request, Shadow Government Statistics began estimating ongoing annual growth in M3, which allows for publication of the non-official data that otherwise would not see the light of day.
As the recent banking solvency crisis broke, the Federal Reserve lent money to banks, as needed, and pumped 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, showed seasonally adjusted annual growth in excess of 2.0%, which slowed 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. The bank reserves were little changed over the year.
So, how can 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.
I have been using the money supply measures in econometric modeling of inflation and economic growth since the early 1980’s. Again, the broadest measure available always has been the best predictor of inflation. The relative size and December 2007 annual growth rates of the various money measures are indicated in the following table.
Some Comparative Money Numbers December 2007 (Monthly Average, Seasonally Adjusted)(Sources: Shadow Government Statistics, St. Louis Fed, Federal Reserve Board)
Measure $Billion Yr/Yr Change
SGS-Alternate M3 12,927 +15.2% MZM 8,111 +12.5% M2 7,458 +6.1% M1 1,363 -0.2% Monetary Base 825 +1.5% Currency (M1) 760 +1.4%
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 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, usually, double-digit broad money growth 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, those events were before many of the methodological changes to the CPI that have resulted in current understatement of CPI reporting. The inflation currently signaled by M3 is not for financial asset inflation, such as in the equity markets. A very short-term leading indicator to financial assets 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.
Week Ahead. Look generally for weaker than expected economic data and stronger than consensus inflation in this coming week’s heavy economic release calendar. Both December retail sales (Tuesday, January 15th) and industrial production (Wednesday, January 16th) should show monthly contractions. Strength in November retail sales reflected poor-quality seasonal adjustments for an early Thanksgiving, which shifted some sales into November from December. If December should be positive, look for a downward revision to November’s growth estimate at the same time. It would not be extraordinary for industrial production to contract in tandem with the indicated production contraction in December’s purchasing managers survey.
Expectations are for roughly 0.2% monthly gains in both the PPI (Tuesday, January 15th) and CPI (Wednesday, January 16th), but there could be some upside surprises as energy-related costs surface in unexpected areas. The seasonally adjusted monthly December CPI gain has to top 0.45% for December’s annual CPI rate to top November’s 4.31%.
Further details will follow in the January SGS newsletter.
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The target for posting of the January SGS is in the week of January 28th. An e-mail advice will be made of its and any intervening Flash Update/Alert postings.