Monetary Base Growth Takes a Breather. After six consecutive two-week periods of growth, the U.S. monetary base took a breather in the most recent reporting. The seasonally-adjusted St. Louis Fed Adjusted Monetary base eased to a level of $2.010 trillion in the two weeks ended November 18th, versus a record-high $2.024 trillion in the prior period ended November 4th, as plotted in the accompanying graph. Accordingly, the annualized rate of growth in the Fed’s primary tool for adjusting money supply in the last three months, since the near-term trough of the two weeks ended August 12th, slowed to 96% from 126% in the period two-week period. On a straight November 14, 2009 versus August 12, 2009 comparison, the Fed has pushed the monetary base higher by 20%. The Fed has been behaving as though it still has a major systemic liquidity problem.

Broad Money Growth Continues to Falter. As has been the case for the bulk of the extraordinary expansion of the monetary base since late-August 2008 — an increase of 129% — the monetary base growth has not been reflected meaningfully in money supply growth. Such remains due to banks placing high levels of excess reserves with the Fed, instead of lending the funds into the normal flow of commerce.

Based on less than two weeks of reporting for November, the monthly contraction seen in the seasonally-adjusted SGS-Ongoing M3 estimate for the last four months appears to be continuing. Based on the current trend, year-to-year change in M3 would turn negative in December 2009. Such would be a leading indicator for an economic downturn in normal times; it would foreshadow a significant turn for the worse in the current, severe economic contraction. As discussed in the Money Supply Special Report of August 3, 2008, the Fed always can drive the economy into a downturn, with contracting money supply, but the reverse does not always work.

Inflation and Slowing/Contracting Money Growth. In theory, slowing or outright contraction in broad money supply growth should be reflected in slower inflation or outright deflation. As with most economic theories, however, there often are simplifying assumptions that may not be appropriate under certain circumstances. Money supply, for example, works best as a predictor of inflation in a closed system, as was seen with Zimbabwe.

In the case of the United States, however, significant dollars are held outside the country, where shifting dynamics may have significant impact on U.S. inflation. To the extent that foreign holdings of U.S. dollars are in stasis, with demand and supply in balance, then the circumstances of the simplified money supply model tend to work. The dollar’s global position, though, is not in balance, particularly with the Fed working to debase the U.S. currency to create inflation.

One distortion up front is in the U.S. currency in circulation, as reported in M1. Something more than half of the $860 billion reflected in the latest M1 reporting is physically outside the United States in "dollarized" countries and elsewhere. 

Separately, as reported by the Fed in its second-quarter flow-of-funds analysis, foreign holders of U.S. assets hold something in excess of $10 trillion in liquid dollar-denominated assets, assets that could be dumped at will into the global and U.S. markets. In perspective, U.S. M3 is somewhat over $14 trillion. (The flow-of-funds analysis has serious data flaws, but the magnitude here likely is reasonably close to reality.)

Helping to fuel those holdings, the Fed has been using the excess reserves deposited with it by U.S. banks to buy troubled mortgage-backed securities from financially stressed institutions, and some of the institutions benefitting likely are located outside the United States.

As excess dollars get pumped into the global markets, a shift in the tide against the U.S. dollar gets reflected in a weakening exchange rate, which in turn spikes dollar-denominated commodity prices, such as oil. That effect has been seen in recent months, with the result that U.S. consumer inflation has started to resurface, not from strong economic demand and a surging domestic money supply, but from distended monetary policies and a global glut of dollars encouraged by the U.S. central bank.

Demand and supply affect the U.S. dollar. Supply soars and demand shrinks with the increasing unwillingness of major dollar holders to continue holding the existing volume of U.S. currency and dollar-denominated assets, let alone to absorb new exposure.

Therein lies a significant threat to near-term U.S. inflation. Heavy dumping of the U.S. dollar and dollar-denominated assets would be highly inflationary to U.S. consumer prices. It also likely would activate heavy Fed intervention in buying unwanted U.S. Treasuries. When the Fed moves to buy Treasuries as the lender of last resort — to monetize U.S. debt well beyond anything seen to date — that also would tend to trigger renewed growth in the otherwise flagging broad money growth.