Friday, October 16, 2009

Is the Fed Really Printing Money?

In this issue:
1) The Skyrocketing Monetary Base
2) The Mattress Full of Excess Reserves
3) Stable Money And Deleveraging
4) Moderate CPI with Lots of Slack
5) Should Goldfinger be Chairman of the Federal Reserve?
Dear Friends, Colleagues, and Investors,Is the Federal Reserve Board (Fed) really printing money? Is inflation inevitable? Continuing last week’s theme of inflation vs deflation, let’s take a close look at what’s really going on with the US money supply.

1) The Skyrocketing Monetary Base
Haters of Fed Chairman Ben Bernanke claim the Fed is running the printing presses in overdrive and this will soon produce severe inflation. Simply put: If we increase the number of dollars in circulation without producing more goods, we'll have too many dollars chasing too few goods and prices will rise - that's inflation. The graph below of the US base money supply seems to support the argument that Bernanke has been increasing the supply of dollars. The "base money supply" or “monetary base” is a measure of circulating currency and commercial bank reserves held at the Federal Reserve. It’s also called “high-powered money” because banks can quickly loan out the reserves and cause credit expansion and possibly inflation. For the best explanation of money and inflation, read the first few chapters of Milton Friedman's "Money Mischief."

2) The Mattress Full of Excess Reserves
Yet the “monetary base” is like gunpowder. Unless the banks actually loan the money out, the money doesn’t increase spending. The banks might as well be storing all that money under a giant mattress. Here’s a look at the excess reserves that banks are holding with the Fed. Taken with the graph above, its clear that the Fed has greatly increased liquidity in the banking system, but most of that liquidity has been given back to the Fed in the form of excess reserves.

3) Stable Money and Deleveraging
The net effect of the increase in monetary base with the increase in excess reserves has been a modest increase in real money “M2”. M2 is a measure of what we usually think of as money: currency, checking and savings deposits, and money market accounts. As you can see from the graph at the bottom-left, M2 grew fairly consistently over the last 20 years, but as the bottom-right graph shows, it has actually been slightly negative over the last 9 months. It’s worth repeating: the amount of money in the US has shrunk slightly over the last 9 months, and only increased moderately in the year leading up to that.

So why has money (M2) been so steady if the Fed is running the printing presses? We already saw that a lot of the money the Fed is printing is just ending up as excess reserves, but that’s just part of the story. The graph to the bottom-left shows the “velocity of money”, a measure of how quickly a dollar gets spent. Consumers are holding on to cash and paying down debt, which has a similar effect to destroying money. The bottom-right graph shows the effect of consumers paying down debt. Consumer credit outstanding is shrinking as banks cut credit lines and consumers voluntarily reduce their debt.
4) Moderate CPI With Lots of Slack
So enough about money, what about prices? The graph below is of monthly changes in the Consumer Price Index (CPI). We've had moderate inflation over the last few months after significant deflation in Q4 2008. Inflation occurs when demand for goods exceeds supply at the old price. Sometimes this happens because of a supply shock (e.g. global oil shortage), but usually it occurs because central banks have been printing money and increasing the supply greater than the creation of actual goods and services. In this case we also have to consider the fiscal side. Programs like “Cash For Clunkers” pull future demand forward to today, artificially increasing the demand for goods in the short-term.

I’ve got one last graph to share with you, and that’s “capacity utilization”. “Capacity utilization” is a measure of how busy we’re keeping our factories, mines, and utilities. The low level of capacity utilization suggests that we could rapidly increase the supply of many goods, reducing the risk of broad inflation. None of this is meant to suggest that we can’t get severe inflation in the future. All those “excess reserves” could quickly get loaned out and produce a dramatic increase in real money (M2) before the Fed could pull it back. Whether that happens will depend on the “animal spirits” that animate business leaders and bankers and the political will of the Fed. This is why so many Fed officials are trying to talk about a "credible exit strategy" - they want to signal to markets and bankers that they will lower reserves just as things pick up, but not so fast as to hurt growth and cause a second recession. Read a recent speech about that here.

5) Should the Evil Bond Villain Goldfinger be Chairman of the Federal Reserve?
In the James Bond movie "Goldfinger," the villain Auric Goldfinger has a plot to detonate a nuke at Fort Knox to irradiate much of the US gold supply. The precious metal supporting the United States' greenbacks would be unusable and effectively destroyed; the ratio of paper dollars to government gold would increase. This would cause the USD to crash (relative to other currencies) and gold prices to skyrocket. It turns out we didn't need Goldfinger's evil plot. In 1968, 4 years after "Goldfinger" was made, the US could no longer support it's gold peg and the price of gold skyrocketed.

Some investors believe Bernanke has a plan that will similarly devalue the US dollar. Henry Ford once said,
“It is well that the people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” The bizarre thing about the populist anger today is that the gold bugs and anti-inflationists tend to be just the people who would actually benefit from inflation. William Jennings Bryan was fighting for the “toiling masses” when he famously said, “You shall not crucify mankind upon a cross of gold.” A gold standard and 0% inflation benefits richer lenders/creditors and hurts poorer borrowers/debtors. Inflation redistributes wealth from the rich and the “fat cat” bankers to people living paycheck to paycheck and to debtors. Want to screw over the wealthy, the banks, and the credit card companies? Tell Bernanke to send the printing presses into overdrive.

Your "Shaken Not Stirred" Trader,


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