The economic momentum seen in the third and fourth quarters is slowing. That point has been evident in the latest reports for durable goods orders, nonfarm payrolls, retail sales, and industrial production to name a few. The weather of course has been trotted out as the most convenient excuse for the slowing momentum, but cracks in that argument are beginning to surface in the same way cracks surface on roadways in the wake of frigid winter weather.
We cited the increase in construction payrolls in January as one disproof last week. This week we can cite the 0.6% decline seen for nonstore retailers (i.e., Internet commerce) in the Retail Sales report and the downward revisions for manufacturing output for each month going back to October seen in the Industrial Production report. To be sure, the weather excuse doesn't fly for October and November like it does for December and January.
If the weather isn't solely to blame, then what is? Everyone is searching for answers as to why the economy can't achieve escape velocity. Sure, it gains some encouraging steam here and there, as we saw in the fourth quarter of 2011 and the third quarter of 2013, but then it soon falls back into the same rut of below-average growth.
The answer frankly lies in the money supply. The problem isn't that there is too little money. The problem is that there is too much money doing nothing or at least very little.
Et Tu, M2?
Technically, the title of this week's column couldn't be further from the truth. Money supply is up (way up).
What's truly down is the rate at which that supply of money is turning over in the economy. We have highlighted this factor before, yet it is worth repeating because it regretfully remains the case.
The M2 component includes the money supply of non-bank issuers, demand deposits, and checkable deposits, which comprise M1, as well as savings deposits, certificates of deposit under $100,000, and money-market deposits for individuals. The ratio for the velocity of money is derived by taking quarterly nominal GDP and dividing it by the quarterly average of M2 money stock.
The St. Louis Federal Reserve indicates in its research that if the velocity of money is increasing, then more transactions are occurring between individuals in an economy. As one can see, the velocity of money is at its slowest pace in the history of this measurement which dates back to 1959.
It's a remarkable statistic given what the Fed has done with its monetary policy and considering corporate profits are at a record high. However, one can quickly see through the morass when looking at the level of loans and leases in bank credit versus the level of M2 money supply. One isn't rising at nearly the same rate as the other since the Lehman Bros. bankruptcy; and that tells the tale knowing the extension of credit is the lifeblood of the economy.
Effectively, the level of bank loans and leases today relative to money supply is near a 20-year low.
Bank on It?
It's not that banks aren't lending money. They are, only they are lending it at a surprisingly slow pace nearly five years after what was determined by the National Bureau of Economic Research to be the trough of the Great Recession. Some of the reasons cited for that slow pace of growth include:
- Increased regulatory burdens
- The interest the Fed is paying on excess reserves, which offers a risk-free rate of return
- A necessary return to tighter lending standards; and
- Low borrower demand for loans
There is some truth in all of the above reasons. The crux of the matter is that there has been a fusion of diffidence between lenders and borrowers.
According to the Federal Reserve's Senior Loan Officer Survey, the willingness of banks to make consumer installment loans isn't all that strong and neither is the demand for consumer loans. What is seen in the charts below is that the net number of respondents showing a willingness to make new consumer installment loans is lower than it was at the end of 2010 while the net number of respondents reporting stronger demand for consumer loans and credit cards isn't all that different from what it was in the middle of 2011.
Another supply issue is the level of liquid assets held by nonfinancial corporate businesses. The latest Z.1 report from the Federal Reserve shows liquid assets at a whopping $1.92 trillion. That's a great supply of money that we'd venture to say isn't earning much or doing much to jumpstart the economy.
Interestingly, the percentage of total liquid assets to total financial assets for nonfinancial corporate businesses has been rising since the middle of 2012, all during a time when the economic outlook has reportedly brightened.
Some are quick to point to all of the corporate cash as a reason why bank loans and credit haven't expanded in faster fashion. In other words, with all of that liquidity at their disposal, courtesy in many instances of the corporate bond market, US businesses haven't needed to take out new bank loans to expand their business.
That may be true for some, yet that act of cash-based expansion has not manifested itself in business investment data. Publicly-traded companies have been actively deploying cash for share repurchases, yet orders for nondefense capital goods, excluding aircraft, reveal a pervasive mode of guarded expansion activity no matter the funding source.
What It All Means
Economists have been bringing down their first quarter growth estimates and are expecting fourth quarter GDP, originally reported to be up 3.2%, to be revised lower with the second estimate. For our part, we're expecting first quarter GDP to be up just 0.3% due in large part to an inventory drag.
Either way, we don't see any reason at this juncture to think first quarter GDP growth will have a 3-handle on it and it will be lucky to have a 2-handle on it. That slowdown has been par for the economic course since the end of the Great Recession.
This time around the weather is drawing blame for the expected growth shortfall. It will admittedly have some bearing on things, but it isn't just the weather.
The bid to sustain 3.0%+ GDP growth is being foiled by a factor that has undercut the economy's growth potential since the recession ended. Specifically, money isn't turning over with animal spirits in anything other than the stock market.
The money supply is there for the taking, but the take on that dole is lacking since the expansion of bank loans and leases has been weak, potential borrowers aren't pining for the credit, and corporations aren't spending their cash with demand-driven conviction.
There is a whole lot of pent-up growth potential in the money supply, but until money starts turning over with more velocity, neither the US economy nor inflation will take off as many thought they might with the Fed's embrace of quantitative easing five years ago.
The future is inherently uncertain, yet lending, borrowing, and spending behavior today imply confidence in the outlook is still lacking -- and confidence is key in changing the impact of the vast supply of money that is doing nothing or at least very little.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.