Inflation-Adjusted Contraction in Broad Liquidity Always Pummels the Economy. Not all economic downturns are triggered by liquidity crises, but all liquidity crises trigger or intensify economic downturns.  In modern economic reporting, year-to-year growth in inflation-adjusted money growth has turned negative only four times before November 2009, and each earlier occurrence signaled either the onset of a major recession or the sharp deterioration in a pre-existing downturn. A renewed fall-off in U.S. economic activity is in place.

This relatively brief Commentary during the holiday hiatus in economic releases is one of the most important pieces put out during the current economic and systemic solvency crises. It begins, using now-available hard data, to lay the base for a severe second downleg in what already is the longest and deepest economic contraction since the first-downleg of the Great Depression in the early-1930s. This story will be explored in greater depth in the upcoming economic review of 2009 and preview of 2010. 

While consensus forecasters and the hypesters on Wall Street and in the Administration already have pronounced the economy to be in recovery, the best case I can make for recent economic reporting is that broad business activity in some areas has flattened out at a low-level plateau of activity, even accounting for one-time upside blips from government economic stimulus gimmicks. Whether coming off a short-lived upside bump or an extended period of bottom-bouncing, what lies ahead should be a renewed plunge in economic activity that will be recognized by all.

Using the SGS-Ongoing M3 Estimate as the broadest measure of money supply or systemic liquidity (the story will soon be repeated in the narrower M2 measure still published by the Federal Reserve), year-to-year change in the nominal (not adjusted for inflation) seasonally-adjusted monthly average turned negative, down roughly 0.7% (a formal preliminary estimate will be published next week) in December 2009, for only the second time in modern reporting of M3 (since 1959). It is in inflation-adjusted terms, however, that the story lies. On a year-to-year inflation-adjusted basis, November 2009 was down minimally by 0.3%. Using conservative estimates for December M3 and CPI, real December M3 was down roughly 3.2% year-to-year.  

Inflation-adjusted money supply long has been used as a leading economic indicator. Indeed, it should have some relationship to real (inflation-adjusted) economic growth, where the formula expressing basic relationships in monetary theory is:

M x V = P x G

Where M = money supply, V = velocity, P = price inflation and G = the level of GDP or economic activity net of inflation (see: http://www.shadowstats.com/article/money-supply).   Holding V constant and dropping it, which sometimes is done to simplify economic concepts, the formula can be restated as:

G = M / P

The plot in the following graph is not intended to show high correlations between the series, other than at every time year-to-year change in real money supply has turned negative, year-to-year change in nonfarm payrolls has followed, albeit with varied lead/lag times. Using the cycle growth troughs in real M3 and employment (employment is a coincident indicator of GDP activity) the lead time between M3 and employment averages six months (1970 was nine months, 1974 was seven months, 1981 was two months, and 1991 was six months). 

From the real M3 series first turning negative year-to-year, to the official onset of recession, the lead time was five months in the 1969/1970 recession, five months in the 1980 recession and 15 months with the 1990/1991 recession (employment data suggest an earlier start to the 1990/1991 downturn) . 

The 1973 to 1975 recession, however, is the closest to the current circumstance, where the real M3 annual contraction did not begin until May 1974. Sporadic GDP contractions were seen following the oil crisis that triggered the recession at its official onset in October 1973. Following the downturn in M3, though, the quarterly contractions became regular and severe, and, as shown the graph, annual employment change turned negative.

GDP usually is the last major series to show a downturn, and GDP reporting tends to follow consensus forecasts. The consensus forecasters will begin to get battered by unexpected weakness in series such as retail sales, housing, industrial production and employment in the next several months, before their outlook likely turns once again to the downside. Nonetheless, the next major movement in broad economic activity already is in play, and it is a big one to the downside.

The general outlook is unchanged.  The renewed deterioration in U.S. economic activity will intensify the systemic liquidity crisis (keep in mind that all fiscal projections from the federal government on down, projections for the soundness of the banking system, etc. all are based on the presumed resumption of U.S. economic growth in the year ahead). This circumstance also will help to trigger the eventual dumping of the U.S. dollar and dollar-denominated paper assets that will begin to feed into a hyperinflation, as discussed in the December 2nd hyperinflation report update.

Week Ahead. With holidays forcing early release of some data, the economic calendar in the week or so ahead remains thin. Given the underlying reality of a weaker economy and a more serious inflation problem than generally is 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.

Payroll Employment and Unemployment Rate (December 2009). Due for release on Friday, January 8th, the employment/unemployment data are at high risk of disappointing what are likely to be fairly optimistic consensus estimates. Extreme seasonal factor distortions may generate unexpected results in this last report before the benchmark and seasonal adjustment revisions are published in February. The outlook for the jobs and unemployment report will be updated next week.