Increase in money supply means recovery is near, some say
Money supply, in vogue again?
Some forecasters say flood of money means economy is recovering
SAN FRANCISCO (MarketWatch) -- Along with shaggy hair on boys and hand-wringing
about inflation, money supply -- that favorite 1970s indicator of economic
cycles -- is making a comeback.
Some economic forecasters and strategists are pointing to a steep five-month
rise in the amount of money held as indicating that a recovery in the U.S.
economy is slowly but surely getting under way.
The rise in the M2 measurement of money supply is saying "monetary policy is
pretty easy and the economy may pick up before the consensus expects it," said
Paul Kasriel, chief economist for the Northern Trust.
Kasriel, for years one of the gloomier private-sector prognosticators thanks to
his early forecast that the U.S. housing market was on the path to meltdown,
now has a sunnier outlook. He expects the economy to start recovering by the
fourth quarter and that it will avoid a prolonged, debilitating bout of
deflation.
One reason, he says, is the federal government's spending to get out of the
financial crisis, which is forcing more money into the banking system. The Fed
has injected roughly $1 trillion into credit markets in the past year by buying
commercial paper and agency bonds, for instance. And the Treasury is issuing
record amounts of debt to underwrite the federal deficit. If the Fed buys back
more of that debt, its puts more money into supply.
Forecasters like Kasriel say some of the government's actions are already
showing up in bank accounts.
The M2 measure of money, which includes currency in circulation, checking
accounts, saving accounts, and balances in retail money-market funds, has
jumped sharply since September.
In January, the M2's annualized growth rate over the previous three months
jumped to nearly 18%. In August, the three-month average growth rate was less
than 3%.
These higher savings, in turn, should spur more bank lending and thus economic
recovery.
"It's not as good as it used to be but it's still better than a lot of things,"
said Kasriel of M2's track record as a predictor. "It does a pretty good job of
foreshadowing what the economy is going to do."
Growth in the money supply was the main contributor to the second straight
monthly rise in the index of leading economic indicators, which tries to
forecast economic activity six to nine months in the future, the Conference
Board said Thursday.
"Because M1 and M2 are growing, there will be an economic recovery," said Craig
Callahan, founder and president of Icon Advisers, a $2.5 billion value fund
manager based in Greenwood Village, Colo. M1 refers to a narrower measurement
of money.
He has been telling clients that the increase in the past half year -- after
three and a half years of modest growth -- means "this economic recession has a
finite life."
Usually, Callahan says, it takes six to nine months for a pickup in money
supply to take effect. That would mean a turnaround is already under way.
The "combination of money supply growing plus the fiscal stimulus means we
would expect the market to move sharply higher in the coming months," he said.
Flashback
Following the money supply down to the fifth decimal place was a popular
activity for economic forecasters from the 1960s to the mid-1980s, when the
actions of the Federal Reserve to pump more money into circulation often
foreshadowed a turn in the economic cycle.
Central banks such as the Federal Reserve also set targets for money supply to
achieve its goals of keeping the economy growing and prices stable.
Those who believe in using the money supply as a leading indicator point to
recoveries such as the one following the recessions in 1973-1975 and the early
1980s as evidence money supply can successfully determine future growth.
For example, by December 1981, the annualized three-month average rate of M2
growth had risen to more than 12%, up from less than 6% in July 1981, the start
of the 1981-1982 recession. By the end of 1982, the economy started an
expansion that would last more than seven years.
Measures of money supply have fallen out of favor with private-sector
forecasters as well as the Federal Reserve in the past 20 years, however. Over
that time period, savers put more of their money into increasingly popular
non-bank investments, such as cash-like bonds and stock mutual funds.
That's one reason skeptics like Zach Pandl of Nomura Securities and Lou
Crandall of Wrightson ICAP say the money supply can't be trusted for insight
into the future.
They say the recent increase in the M2 stems from investors moving money out of
non-bank markets, such as the largely defunct market for auction-rate
securities, into the safety of bank deposits. But that shift doesn't mean more
money is getting circulated.
The increase in M2 "reflects the fact that money is being flushed out of the
shadow banking system and moved into financial institutions that are perceived
to have a safety net for large deposits or which have explicit guarantees on
smaller deposits," said Lou Crandall, chief economist for money-market research
specialist Wrightson ICAP. "It's not increasing the financial resources
available for households for spending."
In recent years, the Federal Reserve has also debunked the merits of using the
money supply to predict economic growth. In 2006, it stopped publishing a third
measure of money supply, the M3, because it decided it was not worth the
resources to collect that set of data.
But the flood of Fed cash into the credit system in this cycle -- and the
ensuing worry that this liquidity spigot will lead to runaway inflation -- has
prompted senior Fed officials recently to spend more time talking about the
impact of money-supply growth.
The higher-than-normal increase in M2 is primarily due to investors' demand for
greater safety, Fed Chairman Ben Bernanke wrote in the footnotes of a speech he
gave Wednesday. "We expect growth in M2 to slow considerably in 2009," he
wrote. The Fed, he said, sees "little risk of unacceptably high inflation in
the near term."
But even the naysayers acknowledge the indicator is making somewhat of a
comeback.
"It's made a bit of a revival now," said Nomura's Pandl. "We're in a period of
unconventional monetary policy. People are looking at different metrics, and
money supply has made a resurgence."
