Sunday, January 25, 2009

Monetary mop-ups

This graph shows the US monetary base - the 'high powered' money that generates the money supply - for the last 100 years.  I assume that this base is generating a less than proportionate growth in the US money stock - M3 grew in 2008 at only about 15% - because of the much-publicised decline in lending.  But if lending were resumed how would the astounding consequent growth in the money supply be 'wound back'?

I am not a macroeconomist so better answers than I can conjecture intrigue me.   Are we in for a massive bout of global inflation as the depression/recession we are going to experience over the next year or so (hopefully) eventually peters out? Or are such massive increases in base money easily reversed by open market sales of bonds (sounds implausible) or increased reserve requirements (also sounds implausible)?

Couple the monetary moves with the latest $819 billion fiscal package and the monetary moves look very expansionary.

One reason for my caution is that econometric models are operating entirely in out-of-sample territory in trying to estimate the effects of these policies. I don't believe any model-based forecasts at this stage.

Comments welcome.


Uncle Milton said...

Harry, it's not inflationary. Start with the identity MV=PQ. There's been a complete collapse in velocity, V, with banks hoarding cash. The huge increase in M makes up for part of the fall in V. But not all of it - the US is in deep recession, as seen by the fall in PQ.

The winding back of M when the US starts to recover should be staightforward enough. The Fed is currently engaging in swaps of M for all sorts of financial and non-financial assets. But these swaps have a limited life. They have to be renewed. When the Fed decides that the recovery is underway, it can decline to roll over these swaps and banks (and others) will be obligeed to give back M in exchange for other assets that the Fed is holding.

jc said...

uncle Milt.

It is eventually inflationary unless of course you think the economy will stagnate into infinity and even I don't don't you would believe that, would you?

Banks are hoarding cash, however bank lending actually hasn't fallen.

The winding back of M when the US starts to recover should be staightforward enough

Nonsense. If the "recovery" occurs because of the monetary expansion a removing the stimulus will abort the recovery.

Furthermore if inflation happens fast as is my hunch the Fed can't act quickly enough.

This is an extremely dangerous game the Fed is playing and it will end with a debased currency unit and another dip into recession as it tries to take away the punch bowl.

However be sure to participate in the next bubble it creates, which is probably US bank stock next year.

The most toxic thing you van ever do is to run an easy monetary policy and a loss fiscal policy. Keynes is certainly getting his revenge

Uncle Milton said...

JC, Bernanke gsve a speech recently at the LSE where he explained how it can be done. It's on the LSE website.

Of course you may think he and the Fed will botch it. In which case, go short on US bonds and you will clean up.

And of course you can always punt long on US bank stocks. They've only got an option value now, so there's not a lot to lose.

jc said...

I’m itching to pull the trigger on an ETF symbol (TDT)which is an exchange traded bond composite but I don't quite think it's just time yet and you could end up losing a lot of money while it gyrates backwards and forwards before it takes off.

I think it will be time in a few months.

This is what I think. Yes, I think Ben has this one wrong and won’t be able to pull back in time to stop the significant inflation hitting the US economy. He won’t be able to because the economy will still be to weak for him to pull the rug out from underneath it.

Paraphrasing what Anna Schwarz said recently, Ben is attacking the wrong side of the balance sheet and is fighting the previous war with the same weapons. So yea, I think he’s dead wrong and will be disastrous inflation wise.

People nowadays misunderstand the concept of deflation, which is first and foremost a monetary problem. Deflation is a significant decrease in the money supply causing a downshift in the general price level.

CPI dropping may or may not be deflation if a drop in the money supply doesn’t accompany it.

I’ve got several trades on at the moment that is a bet on inflation .

I bought gold against both the US dollar and sterling
I am long Citigroup around here and I bought Morgan Stanley as I think the sale of Smith Barney offers MS excellent prospects and will move much higher at the first signs of inflation. I am long Citi because the bad assets are ring fenced and offer them excellent prospects and with the stock price at 3.5 the risk is limited on the downside by the same amount.

here's a good explanation.

jc said...

here's the problem, Milt.

Several third rate economists that talk about nationalizing the banks.

However the real problem for the banks was I believe created by the government in its recent TARP injections.

The problem has now become the issue of tangible equity, that is the market capitalization of these firms.

To some degree the low valuation has been created by the government demanding a low strike price on the value of the warrants that were issued to obtain the TARP. The effect is that the shorts see this supply of stock at low prices and therefore are selling with impunity even at these low levels. Remember that both Citi and BAC have been ring fenced by the the government. Regular buyers of the stock are also standing away well aware of the potential supply coming out and diluting them.

The net effect is that tangible equity is being held down by government intervention.

What the government ought to do immediately is raise the strike price of the warrants and the convertible stock to economic values that actually reflect the NTA of the stocks. Both Citi and BAC are around 20 buck NTA.

The net effect is that it could immediately raise the net tangible equity and the banks could begin to raise capital from the private markets.

Lets hope someone explains this to Obama.

observa said...

The short answer Harry is keep your eye on gold. It's broken the US $900 barrier after trying to lift from $850 for some time and central bankers may have done their dash with holding down paper gold trades now. Physical gold has been trading at a premium to paper trades for some time and all hell may be about to break loose with fiat dough now.