Recent rapid money growth is no cause for concern regarding inflation (yet) and it may portend good news on the economy. The Federal Reserve is starting to print lots of money. I am referring to M2, the broad supply of money that is out there in the economy, including cash, checking deposits, savings deposits, CDs at banks and retail money market accounts. M2 money supply growth, up 10% over the past year, really swung into high gear last spring and has been accelerating ever since, racing forward at a 27%-plus pace over the last three months, lead by big increases in balances held in checking accounts and savings accounts, which could soon spur spending by businesses and consumers.
The increase in M2 primarily reflects the fact that the public is increasing balances held in both savings and checking accounts. Does this represent an influx of deposits of dollars formerly held outside the U. S., possibly in Europe? Or is this merely a response to low interest rates available elsewhere? Is it a renewed flight of capital to the safety of FDIC-insured deposits, as occurred in 2008 - 2009? Or are people beefing up their account balances in order to boost their spending? We shall find out the answer to the latter question as we throw off the dampening effects of the summer hurricane and political crisis (possible Treasury default and the “no guarantee” that Social Security checks would be sent out) and we move into the fall months through the Christmas shopping season.
Growth of the Monetary Base
M2 money growth is different from the much criticized explosive growth of the monetary base, which currently consists mostly of bank reserves (bank money held on deposit at the Federal Reserve), which are not circulating in the economy. Huge excess reserves remain on deposit at Federal Reserve banks, held there by the Fed’s new policy (since October, 2008) of paying interest on reserves, and by banks’ unwillingness to lend more, given the combination of their high credit standards and the low demand for loans. The excess reserves provide a cushion to the solvency of banks and strengthen our banking system.
The growth in these reserves has made the Fed a target of critics who see them as inflationary. They are wrong. The existence of large quantities of excess bank reserves is no more inflationary than the Fed’s perennial willingness to create money out of thin air to supply to the Fed Funds market as loan demand increases. As loan demand rises, it tends to exert upward pressure on the Fed Funds rate (the rate at which banks borrow from each other). As that occurs, the Fed can choose to either raise the Fed Funds rate target to dampen demand, or can accommodate the increased demand by pumping more money into the Fed Funds market (they do this by buying Treasury securities from banks and paying for them with newly created cash, in the form of a bookkeeping entry).
The money supply system is loan demand – driven, dependent on the willingness of businesses and consumers to borrow, the level of interest rates and the willingness of bankers to raise or lower credit standards for loans. If the banking system lends more money, the Fed can, if it chooses, respond by printing more money and the existence of excess bank reserves adds nothing to their ability to do so.
We can ignore the rapid growth of the monetary base since 2008, since that is mostly money that does not circulate and has no effect on inflation. M2, however, does bear watching. Odds are that the Fed will dial back its growth or provide a technical explanation that will reduce the likelihood that it will prove to be inflationary. In the meantime, we can monitor M2 money growth and see if it moderates by early next year. We should also observe whether real M2 growth turns out to be a harbinger of increased economic activity, based on its status as one of the elements of the Conference Board’s Leading Economic Index, designed to forecast the future path of the economy. While it has been one of that index’s less reliable indicators in recent years, perhaps the recent steepness of the rise in M2 will help this indicator regain its mojo as it points to better things to come for the economy. Any positive short term impact of rapid M2 growth on economic activity is likely to appear before the end of this year. Any evidence of increased inflation, if it occurs, will be many months, possibly years further down the road.
Rapid growth of M2 is potentially inflationary. However, it is way too early to raise the alarm here. Milton Friedman, esteemed monetary economist, estimated that changes in the rate of money growth take on average about two years to reach peak influence on the inflation rate. Other economists have shown tight correlations between money growth and inflation. But it takes at least five years, and often longer, for these very high correlations to play out. In the early 80s we experienced double-digit inflation, preceded by and accompanied by double-digit money supply growth. However, it took years for both to build up to those uncomfortable levels. Since that period, there have been several instances that, in response to some financial difficulty, the Fed has provided so much liquidity that it spurred M2 to grow at a double-digit rate for several months, sometimes for more than a year. Each time, the money growth rate fell to more normal levels before there was any noticeable effect on the inflation rate.
Of course, were the recent very high M2 growth rate to prevail over a sustained period of time, a sharp rise in the inflation rate could appear relatively quickly, but it is impossible to say how long that would take. History tells us, however, that it would be a matter of years, not months. That knowledge probably emboldened the Fed to make its recent, remarkable policy statement, announcing that the Fed Funds rate likely would be held low for at least two more years, through mid 2013.
At the present time, it is hard to know what accounts for the rapid growth of M2. Perhaps it is only technical factors or Fed open market operations to be explained by the Fed at a later date. But, for the first time since 2008, bank lending to business borrowers is clearly increasing. And total bank loans and leases have been rising, albeit slowly, since last March, when M2 growth accelerated. Increased bank lending, typically, does lead to the creation of additional money in our economy.