Turning to our longer-term twelve-month rate of growth metrics – more indicative of the underlying trends – and focusing on our preferred TMS2 measure, we find that TMS2 continues to march higher, in April growing at an annualized rate of 11.0%. That’s up 40 basis point from March and 120 basis points from the recent low of 9.8% seen back in November 2010. That’s also the 28th time in the last 29 months that TMS2 posted a twelve-month rate of growth in the double digits, equating to a cumulative increase of some 35% over those 29 months. As readers of the Monetary Watch are aware, the run-up to the now infamous housing bubble turn credit implosion turn Great Recession saw a string of 36 months of double digit growth for a cumulative increase of 48%. So, on the heels of two massive asset monetization programs – namely QE I and QE II – the Federal Reserve has been behind a monetary largesse that, in terms of time and size, is now fully 81% and 73%, respectively of that which brought on the Great Recession. Supported by a QE II asset purchase program likely to extend through the end of June, this means that this, our current monetary inflation cycle, is on track to produce a cumulative monetary infusion of near 40% by the time America is celebrating the 4th of July. Yes, not as large as the last inflation cycle, but one we think has the makings of still more to come.
To that question we now turn. To lay the groundwork, first, as we do each month, a look at TMS2 internals…
A Look at TMS2 Internals
As we have often discussed in our Monetary Watch series, we put a lot of effort into analyzing the drivers behind the growth in the money supply, a component view we call TMS2 by Economic Category andSource. And for the third month running, this month’s component analysis reveals just how important the Federal Reserve’s QE II asset purchase program has been to the continued double digit growth in the money supply.
For first time readers of our Monetary Watch, our component view zeroes in on the who and the how behind the ebb and flow of the money supply, reducing monetary inflation to two basic institutions and three primary venues:
- Federal Reserve, via the issuance of what Austrians callcovered money substitutes: the simultaneous issuance of on-demand bank deposit liabilities and bank reserves, created by the Federal Reserve through its purchase of assets, by writing checks on itself and later, when those checks are deposited by the sellers of those assets in their respective banks, completing the issuance by crediting those banks’ reserve balances at the Federal Reserve for the full amount of the checks.
- Private banks, via the issuance of uncovered money substitutes: the creation of on-demand bank deposit liabilities by private banks unbacked by any reserve cover, created through their issuance of loans and purchase of securities when they pyramid up those loans, securities purchases and deposit liabilities on top of their reserves.
- The Federal Reserve, via the largely passive issuance ofcurrency: the issuance of Federal Reserve notes, created when the public chooses to redeem their on-demand bank-issued deposit liabilities for currency. In contrast to covered and uncovered money substitutes, the issuance of Federal Reserve notes is by and large neutral with respect to the total money supply, as it simply substitutes one form of money, namely covered and/or uncovered money substitutes for another, namely currency.
The combined total of covered money substitutes plus currency is what economists call the monetary base, and by definition completely under the control of the Federal Reserve. And the issuance of covered money substitutes is more popularly known as quantitative easing or QE.
With those definitions in mind (for a more thorough discussion see True “Austrian” Money Supply Definitions, Sources, Notes and References), and again nothing new to current readers of THE CONTRARIAN TAKE, one look at the charts below reveals exactly who has been behind the move in the money supply these past several months, really for the entire 2011 year – the Federal Reserve via the issuance of uncovered money substitutes:
Uncovered money substitutes grew at an annualized rate of 112.7% in April taking the three-month rate of growth to an annualized 258.7% and the twelve-month growth rate to 36.7%. Such is the result when the Federal Reserve is monetizing U.S. Treasury debt at annual rates that look like this:
In contrast, private banks continue to shy away from the money creation business, the result being a three-month rate of decline in uncovered money substitutes of 15.1%, down some 4% from the start of the year. As to those more important twelve-month rate of change metrics, while still growing at a rate of 5.5%, uncovered money substitutes are now scraping two year lows. A look at the relative twelve-month rates of growth in uncovered versus covered money substitutes underscore the recent trends:
So, with the Federal Reserve possibly exiting the QE asset purchase business, at least for now, is that all she wrote this monetary inflation cycle? We say maybe not. Why’s that?
Enter…
QE III Courtesy of the Private Banks
First, the Federal Reserve may be ending its current QE II asset monetization program, but it’s not it seems looking to hike its zero to 25 basis point targeted federal funds rate any time soon. And that means it will more than likely be having to supply at least some base money to the banking system (whether that be through Federal Reserve loans or asset purchases) to keep that federal funds rate in check. So yes, the Federal Reserve will not be juicing the money supply at any where near the roughly $75 billion per month rate that we are currently experiencing under QE II, but additions to the money supply their will likely be courtesy of the Federal Reserve.
Second, and far more important, the private banking system will by June’s end be sitting on somewhere between $1.6 and $1.7 trillion in excess reserves, meaning the fuel for the banking system to expand the money supply is in a word explosive. Indeed, at a reserve requirement ratio of 10% (the most restrictive reserve requirement ratio currently imposed by the Federal Reserve on private banks) the private banking system – if it be willing to lend, or if it can’t find willing/able borrowers at the very least be willing to buy existing securities – is in a position to expand the money supply by a massive $17 trillion. On a TMS2 metric that as of April 2011 stood at $7.6 trillion, we are theoretically looking at a money supply some 3.2 times higher than today.
Will these private banks do it; that is, create money by pyramiding up their reserves via the issuance of loans or purchase of securities? As we discussed in last month’s Monetary Watch, maybe. In fact, the end of QE II, meaning an exit by the Federal Reserve from the longer-dated end of the bond market, combined with still ultra-cheap short term funding rates, may be just what private banks need/want to get them back in the money creation business. To quote ourselves from last month’sMonetary Watch…
What if the Federal Reserve ends its asset purchase program in June, beginning the so-called normalization of monetary policy? Will longer-term rates rise, and rise enough to induce banks to lever up their excess reserves, get them to re-enter the money creation business through the purchase of existing, now higher yielding securities? Maybe. With the Federal Reserve’s zero interest rate policy, short term money will still be incredibly cheap, meaning the interest rate spread between long maturities and short-term funds – like excess reserves – will become all the more appealing. As we posited on previous occasions, ripe for the taking could be higher yielding U.S. Treasuries, even for capital deprived banks. They’re as safe and as liquid as securities come, carrying as they do a near guaranteed put option via the Federal Reserve’s printing press.
Speculating a bit more, perhaps this is exactly what the Federal Reserve has in mind. After all, the Federal Reserve is currently financing near 100% of the government’s borrowing needs. And the last thing the Federal Reserve (not to mention the U.S. government) wants to see is a dramatic spike in long-term interest rates if/when the Federal Reserve ends its QE II asset purchase program. Fifty bps, 100 bps, maybe even 150 bps more on the 10-year Treasury may be the least worst option. The banks take over the money printing duties of the Federal Reserve, help contain the cost of U.S. government borrowing and the Federal Reserve gets some much needed inflation fighting credibility. Besides, if they’re not going to lend or buy much in the way of risk assets, at least private banking institutions can continue to recapitalize their balance sheets, making them and the Federal Reserve happy.
Echoing our thoughts, in an April 29th INTERVIEW with Eric King onKing World News, Chris Whalen, Co-founder of Institutional Risk Analytics and noted bank analyst, underscored the need for the Federal Reserve to let longer-term rates rise and for private banking institutions to try and capitalize on that rate rise, if you will to juice their profits by re-entering the money creation business. In fact, as Chris suggests, it could be now or never:
But I don’t know how they [the Federal Reserve] can ignore what is going on with the financials… if we don’t let rates start to rise we are going to have a very serious problem with the banks because they’re not making any money. You know their net interest margin is falling, their revenues are falling, in part because there is very little demand for credit out there. But just the reinvestment issue – you know as stuff rolls off and the banks have to go out and replace the assets – they’re getting half the cash flow they were getting on the old assets. So it’s really hurting their profitability in the medium to long term.
Net net… with a still generally supportive Federal Reserve willing to keep interest rates at the zero bound for “an extended period of time” combined with a banking system possibly willing, indeed needing to buy existing securities enmasse, this monetary inflation cycle could be far from over. Perhaps then, in contrast to those that say this monetary inflation cycle is over with the end of QE II, an end to QE II could very well herald in QE III courtesy of the private banks. We agree, speculation but something we will be watching very closely.
Having said this, and building on Chris Whalen’s thesis, one final thought. With the end of QE II, if private banks turn out to be a no show in the money creation business, a deflationary, not inflationary scare likely lies directly ahead. You see, as the Austrians teach, once an inflationary boom begins it by necessity must end in a bust. Indeed, unless an inflationary boom is fed with more and more inflationary credit a deflationary bust we will quickly get. And with the first signs on an ensuing bust, a massive QE III effort courtesy of deflation hawk extraordinaire Ben Bernanke is sure to follow. In other words, if the private banks don’t inflate, a deflationary scare first than another Federal Reserve orchestrated inflationary cycle. In the end, QE III one way or another.
And now, some final thoughts on M2…
Mainstream Money Supply M2
M2, the mainstream’s favorite monetary aggregate, posted a year over year rate of growth of 5% in April. And while that’s up 140 basis points from December’s 3.6% and marks the highest year over year rate of growth since November 2009, it’s up just 10 basis points from April’s 4.9% rate. To M2 watchers, that suggests a possible slowing in the rate of monetary inflation from an already relatively modest rate of growth. As readers of this site are aware, although THE CONTRARIAN TAKE posits M2 as a grossly misleading measure of the money supply, the mainstream does not. They think M2 is a perfectly fine measure of the money supply, meaning the gap between the true rate of monetary inflation as measured by TMS2 and the perceived rate of monetary inflation as measured by M2 is a hefty 600 basis points. That’s a true rate of inflation 2.2 times faster than the mainstream view. As we discussed in The Bernanke Arbitrage, not only does this faulty M2 metric make someone like Chairman Bernanke, steward of America’s money supply, susceptible to monetary policy errors, but it could very well make currency, commodity, bond and equity investors, that include that M2 metric in their investment deliberations, prone to investment errors that down the line could cost them a great deal of money.
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