The American money supply has exploded. What should we expect next?

The Federal Reserve is aggressively loosening monetary policy, but the story behind the recent increase in money supply is much more complex (and interesting) than simply attributing it to the expansionary policies of the Federal Reserve. This will spur stronger economic growth, but using historical (and outdated) rules of thumb to predict high inflation is too simplistic and most likely incorrect.

Even unprecedented intervention cannot make individuals and businesses take more risks.

The money supply in the United States has grown at an unprecedented rate. M2 rose 3.8% in March, 6.7% in April and 5.0% in May, an astonishing 83% annualized growth rate over three months. This brought M2’s year-on-year growth rate to 23%, almost double its fastest rate in the modern era. Money supply has grown rapidly in other countries as well. Traditionally, rapid money growth would indicate booming economic growth and runaway inflation. But he doesn’t do it this time around, because extreme uncertainty and fear drives people to hoard money.

As the Fed pursues aggressive monetary easing, the recent increase in money supply since March reflects risk aversion and the impact of US government fiscal initiatives more than that of monetary policy.. Undoubtedly, the Fed is pursuing unprecedented monetary easing. Its quantitative easing – massive purchases of Treasuries and MBS that pushed the Fed’s balance sheet up from $ 4.1 trillion in February to nearly $ 7 trillion today – has inflated the monetary base (MB), which includes bank reserves plus currency, over $ 2 trillion. The Fed’s emergency lender of last resort facilities, providing liquidity to short-term funding markets, buying corporate bonds and municipal debt, and lending directly to businesses, flooded financial markets and added to its balance sheet. Money supply M1 includes foreign currency, sight and other check deposits, while M2 also includes non-transactional items, such as savings deposits, small denomination term deposits, and retail money market funds. Unlike the Fed’s quantitative easing following the 2008-2009 financial crisis, which inflated the monetary base but did not materially affect the broad money supply, the recent expansion of the Fed s balance sheet ‘is accompanied by a significant increase in M2.

In early March, businesses turned to extreme risk aversion in anticipation of the spread of the pandemic and government shutdowns that would end their cash flow. Many companies were also concerned that their banks would reduce their lines of credit. They used their unused lines of credit and left most of the proceeds in their bank accounts. Bank deposits, the main component of the money supply, have increased as a result of the accumulation of liquidity by risk-averse businesses and households, as well as U.S. government tax programs that have provided more than $ 400 billion in personal income assistance and hundreds of billions of loans. and grants to businesses that increased deposits in their bank accounts.

According to official data the Fed collects from commercial banks, commercial and industrial (C&I) loans rose 9.3% in March, by far the largest increase in history, and simultaneously, bank deposits also increased. experienced their largest monthly increase on record. Risk-averse households contributed to the increase in measured deposits by reducing their exposure to the faltering stock market, which fell 19% in March, and by mobilizing liquidity. Demand deposits and other check deposits rose 10.4% in March, while savings deposits (including MMDAs) rose 2.8%. These percentage increases were off the charts compared to their historical trends. Reflecting these peaks, M1 rose 6.4% in March, while M2 rose 3.8%.

Even larger spikes in bank deposits and money supply that occurred in April and continued in May were linked to fiscal policy. The CARES law, enacted on March 27, provided for $ 1,200 for individuals ($ 2,400 for couples) and $ 500 for children. Payments were phased out for individuals and couples with adjusted gross incomes over $ 75,000 and $ 150,000, respectively, up to $ 99,000 and $ 198,000. According to the Bureau of Economic Analysis (BEA), the CARES Act provided $ 300 billion in direct payments to individuals. The government distributed the one-time income support checks in April and May. In addition, the CARES Act improved unemployment insurance by an additional $ 600 per week and extended the program to millions of self-employed workers (contract workers) who had traditionally not been eligible. The dramatic increase in improved unemployment benefits was accentuated in April and May with the increase in the number of unemployed. The BEA estimates that $ 144 billion in unemployment benefit payments were made during those two months.

As cash-strapped beneficiaries cashed the checks they received from the government and immediately spent the proceeds on basic necessities, much of it was deposited into bank and credit union accounts. These deposits, plus sizeable (but not dramatic) increases in currencies, are reflected in monetary aggregates in the form of very large monthly increases in M2 of 6.7% in April and 5.0% in April. may.

The implications for the economy and inflation

The economic recovery mainly reflects the end of the government shutdown and the ebb and flow of the pandemic. Of course, aggressive monetary and fiscal policies (including the Fed’s direct corporate lending programs on behalf of the Treasury and Congress) influence economic activity, but a key determinant of the pace of the recovery is confidence. of households and businesses in the health and medical problems associated with the pandemic.

Strikingly, disposable income actually increased when unemployment in the United States rose at its fastest rate in history, as the dramatic increase in government transfer payments more than offset the drop. wage incomes, which fell 8.6% on a cumulative basis from March to May, a huge annualized decline of 30.2% (see Chart 5). With consumption constrained by government closures and cautiousness in the face of the pandemic, personal savings jumped to $ 6 trillion annualized, and the personal savings rate (the change in disposable income minus consumption) jumped. up 12.6 percent in March, from 32.2 percent in April, and remained high at 23.2 percent in May. The level and rate of personal savings have reached their highest values ​​in history. This suggests that consumers have a significant amount of pent-up demand for goods and services. Additionally, low interest rates and Fed bond purchases lowered mortgage rates and boosted the housing market.

As the economy reopens and confidence increases, households will spend some of their savings, boosting consumption, and businesses will reduce their deposits to fund basic business operations and repay bank lines of credit. The points of M1 and M2 will reverse. The level of economic activity will increase. The simple assessment that the currency rise will lead to a pickup in growth will be correct in terms of direction. But even if there is a powerful V-shaped recovery, the naive monetarist perspective will be completely wrong in its assessment of the magnitude of the correlation between money growth and real economic growth, and will most likely greatly overestimate the results. inflationary consequences of the M2 surge. The risks of unwanted high inflation will only materialize if the powerful currency created by the Fed generates supported acceleration of economic activity which results in excess demand in relation to production capacity. This risk should be closely monitored, but it is inappropriate to include it in a baseline forecast.

The increase in the money supply will eventually reverse as businesses reduce their C&I loans and deposits, households spend some of their deposited savings, and the government cuts parts of its generous income support programs. This slowdown in monetary growth will unfold even if the Fed prolongs its aggressive monetary easing.

As evidenced by the decline in C&I loans over the past five weeks, businesses have already started to pay off their lines of credit, reducing their bank deposits. C&I loans typically decline during recessions and early stages of recovery, and this trend appears likely to continue in the current cycle. To date, the decline in business deposits has been more than offset by the increase in consumer deposits, reflecting continued government income support payments to individuals. The government’s improved unemployment benefit is expected to expire at the end of July. While we expect the basic unemployment insurance program to be extended, the status of the subsidized amounts is uncertain, which will affect bank deposits and the money supply.

The M2 spike does not imply a surge in inflation, unless there is a sustained surge in aggregate demand, but combined with the unprecedented increase in deficit spending aimed at stimulating the economy, the risks of inflation are important and need to be watched closely. While the sharp economic contraction in the first half of 2020 resulted in insufficient aggregate demand and downward pressure on prices, rapid and sustained nominal GDP growth would generate excess demand and inflation. This would require the big power money the Fed is pumping into financial markets to be used in the real economy. The sustained low inflation since the 2008-2009 financial crisis occurred because the Fed’s aggressive QE during the economic expansion resulted in excess reserves in the banking system and did not generate a sustained acceleration in nominal GDP . This time around may be different: The combination of reopening the economy and unprecedented expansionary monetary and fiscal policies may be a formula for generating excess demand and high inflation.

Mr. Levy is Chief Economist, Americas and Asia at Berenberg Capital Markets LLC, and a member of the Shadow Open Market Committee of the Manhattan Institute.

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