M3 Contraction Continues. The most common questions I am receiving at the moment are: (1) Why is M3 contracting, particularly with the Fed pumping tremendous liquidity into the markets; and (2) How can you be looking at inflation, let alone a hyperinflation, when M3 is contracting? Those issues have been covered in prior writings, but they are reviewed anew in this Commentary.

As shown in both the shorter- and longer- range graphs of nominal (not adjusted for inflation), year-to-year change in the SGS-Ongoing M3 Measure sank to a post-World War II record contraction of roughly 5.9%, following a 5.0% contraction in April.  Data detail and other graphs are available from the Alternate Data page for M3.

Although the M3 downturn still is relatively small versus the 1930s banking crisis, the May 2010 annual contraction was the deepest money shrinkage since a 7.3% annual drop of the broadest money supply measure in January 1934 (comparative data from Milton Friedman and Anna Jacobson Schwartz’s A Monetary History of the United States, 1867-1960). Keep in mind that the May 2010 annual drop was against a 7.1% annual gain in May 2009, while the 7.3% annual decline in January 1934, was on top of annual declines of 4.5% in January 1933, 11.9% in January 1932, 1.6% in January 1931 and 1.5% in January 1930, a cumulative contraction over five years of 24.4%.

As to what is shrinking in M3, the roughly $871 billion drop in the estimated seasonally-adjusted May 2010 M3 largely was due to a $642 billion decline in institutional money funds (reported by the Fed), and $126 billion drop in Fed-reported large time deposits with commercial banks, although the balance on large time deposits, repos and Eurodollars, which are modeled, also are estimated to be contracting on an annual basis. Where nominal M2 remains up by roughly $142 billion, or 1.7% year-to-year, as with M3, real annual M2 growth has turned negative, again using the CPI-U for deflation.

The contractions in M3 are despite the explosive growth in and continued high levels of the monetary base, which remains the Federal Reserve’s traditional tool for changing money supply growth. Consisting of currency in circulation and bank reserves, the $1 trillion-plus increase in excess bank reserves has the potential to have added more than $10 trillion dollars to roughly $14 trillion in existing M3, today, but it has not.

As to why M3 is in decline, the answer lies in declining lending by banks. Instead of lending their massive excess reserve into the regular flow of commerce, banks are leaving them on deposit with the Fed. Where the Fed has become something like a commercial lender, in terms of fostering purported stability in the mortgage and commercial paper markets, any funds that have gotten into the system are reflected in the usual money supply components.

Updated credit numbers (including today’s — June 7th — release of April consumer credit) continue to show lending in contraction, as indicated by declining levels of short-term credit in the graphs that follow. In terms of year-to-year change, consumer credit (April) is down by 3.2%, commercial and industrial loans (May) are down by 17.6%, and commercial paper outstanding (May) is down by 17.0%.

 

 

 

One misperception is that a debt collapse triggers a money supply collapse. That is not accurate; it is reduced lending that can reduce money supply. If a bank lends a customer $10,000,000, and the customer defaults, the bank likely is not going to recover the $10,000,000 that has been distributed into the broad money supply system by the customer’s spending. Instead, the bank takes the loss on its balance sheet and suffers in terms of the amount of lending it can offer. It is as bank loans are retired and lending declines, due to balance sheet or other restrictions, that money supply begins to shrink.

Another common misperception is that money contractions may reflect investors moving their assets into stocks, etc. Usually that is not the case, since the buyer writes a check against his or her checking account, while basically the same amount gets deposited into the seller’s checking account, with the transaction being money-supply neutral.

Transactions that are not money-supply neutral involve the Fed selling (taking assets out of the money supply) or buying (adding cash into the money supply) assets such as Treasury securities, where the funds end up having impact on privately held accounts in the money supply.

Implications for the U.S. Economy and Inflation. The graph below shows real, or inflation-adjusted, annual M3 growth plotted against the timing of formal recessions, as determined by the National Bureau of Economic Research (NBER). M3 is deflated here by the government’s consumer price index CPI-U.

Whenever real annual M3 growth has turned negative, the economy has followed. Although there have been recessions that were not triggered by contracting real liquidity, every time real M3 has contracted, the economy has fallen into recession shortly thereafter, or, as in the case of the 1973 to 1975 recession, where the M3 contraction took place after recession had started, the existing downturn has intensified.

In the present circumstance, the end of the particularly long and deep recession has not been called by the NBER. In the event the NBER calls an end to the downturn as of some point in 2009, then the real annual M3 contraction that began in December 2009 should prove to be a signal for a double-dip recession, as opposed to ongoing recession and the intensified downturn that appears to be getting underway.

 

 

For those who define inflation in terms of changes in money supply, the current environment is one of deflation. The inflation I discuss, however, is defined in terms of prices for consumer goods and services, and costs there seemed to be reasonably well contained as measured by the CPI-U. Where many people sense that their actual inflation is running higher than that reported by the government, such is covered by the SGS-Alternate CPI, yet the magnitude of inflation problems ahead will dwarf any issues as to how the CPI is measured.

Inflation fears from a post-World War II record decline in broad domestic money supply certainly are counter-intuitive, but that is because the inflation problem is two steps removed from inadequate liquidity strangling business activity. As suggested by the discussion above of contracting real M3, the economy is headed into an intensifying downturn or double-dip recession, which should blow apart forecasts of the federal budget deficit and related Treasury funding needs, as well as trigger massive selling of the U.S. Dollar. Those issues — resulting from the effects of the liquidity squeeze — are what threaten an early breaking of the ultimate inflation crisis. Otherwise, I refer you to the Hyperinflation Special Report for a longer term outlook on the pending hyperinflation.

Formal estimates of the federal budget deficit, as well as results of the stress tests applied to banking-system solvency, are dependent on assumptions of positive economic growth in 2010, not renewed contraction. Ahead lie likely increased federal bailouts of banks, the unemployed, insolvent states, etc., which will balloon the deficit and Treasury funding well beyond current market expectations. 

As U.S. solvency issues once again move to center stage for the global markets, the U.S. dollar should come under broad, heavy selling pressure. With global and domestic investors increasingly balking at funding the Treasury’s needs, the Federal Reserve will have little option but to become the lender of last resort, monetizing federal debt in a manner that will start to inflate the domestic money supply. Money created by the Fed though buying of Treasuries will flow directly to the checking accounts, etc., of those receiving the Treasury’s checks. The Fed and Treasury are likely to act accordingly, since the alternatives involve high risks of systemic collapse, financial-market collapse and cessation of normal government functioning. It is the nature of the political system to buy as much time, to push intractable problems as far into the future, as possible.  

As to the total money supply of dollars, it is important to consider the effective U.S. dollar money supply that also is held outside the United States. The Federal Reserve reports that more than half (purportedly about 70%) of the U.S. dollar currency in circulation, otherwise reported in the domestic M1, is physically outside the United States. Beyond that, there are at least another $7 trillion dollars in cash or near-cash instruments, not counted in the domestic money supply, which could be dumped overnight, if those holding the dollars so chose. Dumping of U.S. dollars and dollar denominated assets would pummel the dollar’s exchange rate, triggering inflation pressures and exploding domestic money supply growth, depending on Federal Reserve actions. 

A weakening dollar usually triggers higher oil prices (and vice versa), denominated in U.S. dollars. That pattern has been seen consistently in the last several years of crisis. Oil is the dominant commodity in terms of impacting costs of consumer goods and services, ranging from energy, fuel and transportation costs, to raw material in many chemicals, fertilizers, pharmaceuticals, plastics, etc.