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Two weeks ago, we looked at money supply and its recent slump, making the comment that “the MS seemingly haven’t had the same predictive power” as they had in the past. We said this only because the Federal Reserve said it first. In the November 2005 Federal Reserve press release on the discontinuance of M3, the Board of Governors states:

M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years.

To understand why the Fed would place less importance on money supply, see the graph below (click to enlarge). We’ve graphed our preferred metric of money supply, M2 plus institutional money funds, against the Consumer Price Index (CPI).

Click Here to Enlarge Chart

During the inflationary 1970’s, surges in money supply growth predicted surges in CPI inflation, with what appears simplistically to be a 3-4 year lag. The long period of disinflation that began in the early 1980s was also corroborated by the money supply data. However, the money supply spike that you see in the late 1990s never leaked into CPI in any meaningful way. By the time money supply growth had come back down to earth in 2004, without any flare in inflation, the death knell for monetarism had seemingly been sounded, and within a few years M3 was no more.

It has been said, most notably in the pages of Grant’s Interest Rate Observer, that we measure inflation too narrowly, that money chases different things in different cycles. So what was the money chasing in the late 1990’s if it wasn’t leaking into the general price level? What about the more recent cycle from 2005 to 2008?

What follows is a little bit of fun with graphs. First, the late 1990s, a period in which money appeared to chase paper assets, namely common stock certificates.

Click Here to Enlarge Chart

The relentless march higher in both of these data sets took them from historically “normal” levels in the mid-1990s to impressive (and unsustainable) heights by the turn of the century.

The most recent period of abnormal money supply growth lasted from 2005 through 2008, where M growth reached 1970’s levels while CPI inflation barely topped historical norms. The lasting story of 2005-2008 is likely to be one of miniscule risk spreads and the explosion of the securitization market. The amount of non-agency RMBS and CMBS outstanding more than doubled from the end of 2004 through the end of 2007, according to SIFMA data. Asset-backed lending surged, as you can see below (click to enlarge).

Click Here to Enlarge Chart

We could show other versions of this connection, perhaps plotting money supply against the origination volume of the alphabet soup of securitized products that we’re now all too familiar with. Money searched out yield in the form of increasingly more complex structured products, many of which were synthetically created and not actually backed by physical securities. These securities were created out of thin air simply because there was more demand than supply (sounds like inflation, right?). Global synthetic CDO issuance went from $7.2 billion in the first quarter of 2005 to $25.4 billion in the first quarter of 2007. It’s no surprise that, as money supply growth has fallen off, there were only $254.3 million synthetic CDOs created in all of 2009. We could also track money supply growth to home prices, or the CRB commodity price index.

Rising money supply measures won’t tell where the inflation will show up, but they can serve as an early warning system for when you need to start looking. If the Fed wants to be more vigilant of asset bubbles, perhaps watching the money supply is a good place to start. The money will be chasing something, and it might not be the goods and services in the CPI basket.

Source: Inflation Chartbook: Follow the Money Supply