Rising Money Supply and the Economy

In early 2006, a friend of mine named Mike wrote to me saying he was worried about the Federal Reserve's decision to stop publishing M3 money supply statistics. He thought it could be a prelude to inflation and trouble for the stock market.

The M scale is a way of measuring money, proceeding from M0 on the narrow end of cash to M3 on the wide end including foreign deposits. Here's how they stack up:

• M0: This is the most liquid measure, and looks at just the actual cash sloshing around the economy.
• M1: Includes M0 and checking accounts.
• M2: Includes M1 and small time deposits of less than $100k, savings deposits, and individual money market funds.
• M3: Includes M2 and large time deposits of $100k or more, institutional money market funds, repurchase agreements, and dollars held at banks in Canada and the United Kingdom.

In March 2006, the Federal Reserve stopped publishing M3 data, saying that doing so would save it money and that M3 added no additional useful information about the economy beyond what M2 already showed.

But, is that true? You don't have to be an economist to see from the list above that M3 is the broadest measure of money in the economy. For more than two years, we've had no official data for deposits of more than $100k, institutional money market funds, repurchase agreements, or dollars stashed in Canada or the U.K. The worry voiced by Mike and others was that by hiding the growth of big money, the Fed made it easier for itself to inject billions of digital dollars into the economy without anybody noticing.

They wouldn't do that, though, would they? Sure they would. Even back when M3 was tracked, the Fed grew it at a rate of 8% per year. A chart showing 8% annual growth jumps off pages to even uneducated eyes, so away went the chart. Growing the money supply by so much is bound to have an impact on inflation, so the consumer price index was replaced in 2000 by "core inflation" as the way the government reports inflation. Core inflation checks the price of everything except energy and food.

Of course, that makes sense, because only people who turn on lights, drive cars, and buy groceries are affected by energy and food prices. Surely you're not part of that odd bunch.

So, by hiding the rising cost of energy and food, and not reporting the growing supply of dollars each year, the Fed cleared a nice path toward opening the money spigot to full blast. Corporations are all for this recipe because they award salary increases based on the cost of living which now does not include energy or food, so they can freeze or even lower wages. Higher prices for goods and services sold, coupled with lower employee wages, equals more profitable companies, which must mean a healthy economy. Ta-da! Just like that, the economy is a gem again, thanks to the working stiff.

As investors, we're supposed to think like corporate management in the pursuit of all profits all the time. We're not supposed to care about workers. To hell with them. The less our companies can pay for their productivity, the better. You know the old saying: pay them just enough so they won't quit.

In theory, then, the rising money level combined with fudged inflation stats to create more profitable companies should lead to higher stock prices. It hasn't, though.

Since M3 stopped being tracked in March 2006, it has gone parabolic. You can't get data from the Federal Reserve anymore, but other organizations have pieced it together from weekly Fed reports. For example, the key stats section of nowandfutures.com provides charts showing that M3 was $10.25 trillion in March 2006 and has risen 32% to $13.50 trillion now. That's a big expansion of the money supply in just 27 months.

By chance, have you noticed anything getting more expensive during those 27 months? You have to look carefully, so let me help.

According to the Energy Information Administration, the average price of a gallon of regular grade gasoline in the U.S. was $2.25 when M3 data disappeared. Today, it's $4.10 and approaching $4.50 in some areas.

According to the Bureau of Labor Statistics, a pound of white, all-purpose flour cost 33 cents when M3 data died. In May of this year, it was 53 cents. A dozen grade A large eggs went from $1.30 to $1.93.

Inflation is here. Another way to put it is that a dollar is worth less today than it was a couple of years ago. That's true at gas stations and stores, as shown above, and also at the currency exchange where 27 months ago one euro bought $1.20 and one dollar bought 119 yen. Today the euro buys $1.58 and the dollar buys only 106 yen.

Which might explain what the Federal Reserve was really up to. The dollar is still the world's reserve currency. We pay for imports with dollars. Those sending us the goods and collecting the dollars as payment, such as China, deposit the dollars in central bank coffers or convert them to local currency. The central banks take the dollars and buy U.S. Treasuries. The U.S. government wants to pay that debt back with dollars as cheap as possible, which has been arranged.

What are the practical implications for individuals?

One is that this financial engineering may mean little to the stock market. On the one hand, rising profits from an inflated money supply and stagnant wages should get stock prices moving higher. On the other, higher energy prices could offset the savings from low wages.

Indeed, when we look back at the history of M3 in America, we see it rising steadily from about $0.80 trillion in 1970 to $4.00 trillion in 1995, then taking off to its current $13.50 trillion. During that time, we've seen bear markets, flat markets, and bull markets in stocks. We've also seen runaway inflation in the 1970s and benign inflation in the 1990s.

So, while Mike was right about the end of M3 data kicking off a race higher in the money supply, it's not clear that it's an automatic stock market killer. What is clear is that the situation is not good for American workers.

Comments

[kotika98]

>the situation is not good for American workers

are you here to recruit for the Communist Party of America or to give "investment" advice?

[ArcticFox]

It's interesting to note the sharp rise in both volume of trading and price in the DOW Index since the mid-90's, and also the sharp fluctuations. Could it be that the market is inflated do to the weakening of the dollar and the increasing of supply money to financial institutions. It's clear also that most of these dollars end up as profits gained from securities cashed in by insiders and market makers such as Goldman Sachs. The rich get richer at the expense of the working man, and the government plays right into their money basket.

[iThinkBig]

American workers matter Kotika. Why? Because 80% of our economy is a service model. 51% GDP comes from megacorporations and government. The other 49% GDP is what is consider Main St. Our of that, 70% is small business. That 49% has been mostly ignored from years from the investment community and government with government now being considered a predator to group. But it was obvious to me in June of 2007 when I ran broad-based economic research that Main St. will drag down Wall St.

Inflation and stagnant wages, skilled job destruction means little discretionary spending by the 49%. Considering spend and spend has been our economic model, the Efficient Market Hyposis has has failed as a model. No employer (I own a Consumer Healthcare marketing company), wants to see wage inflation on top of every other challenge. But investment into the 49% will accelerate next year and I assume wage inflation will occur in shortly thereafter.

Right now it has become an employers market, but one that is challenging as employees still retain many bad habits from having it good and relatively easy over the last 15 years. Management has had to be creative to incentive increased production while retaining profits.

The megacorporations will be see inflation exported back to us specifically from China, it will certainly make an impact on the bottom line. Government will be the last to hack budgets but there will be little choice. It's gonna be a rough ride for the next three years and if we escape depression-like conditions I will be amazed. In between, firesales are popping up everywhere, but my timing to buy is Q3 of 2009 and thereafter.

[iThinkBig]

You're correct ABF, it was taken out of the little guy for years. Now we see the results of Cause and Effect. Our economy needs a balance and investment into small businesses and innovation. The 97% of the citizenship will not tolerate being serfs to serve the nobles for long. This is not medieval times, the 97% are getting educated as to why this is happening in short order as they research personal finance (out of necessity). 60 million Americans are armed and our military is losing patience with being treated by the party in power as lower then dirt. An armed revolution in a few years would not be surprising, especially if the financial house of cards folds and short-term anarchy emerges.

I know, some of you probably think I am a conspiracy theorist. No, I am a student of history and human nature and have done very well financially because of this knowledge of statistical probability (what religious people call prophecy) based on human nature and our violent evolution towards a unified globe.

[gordon]

The elite financial media is time & time again boasting that inflation is under control, unlike the 1970s, because WAGES ARE SUPPRESSED, PRESSURED, this is all good, right? Yesterday one of these bastards reminded of the Union job crushing that has been successful. UNH stock has been in a death spiral for months and I told my wife, watch, they're going to eventually come-clean that millions of Americans are dropping health insurance. SURE ENOUGH! No ethical and moral country operates like this. My hat's off to Venezuela banning short-selling. Just look at the abolishing of the uptick rule to see these bastards are conspiring. Everywhere you look it's a conspiracy, plain as day. Like McCain going to Columbia only to find those hostages were "ready to go, in the can" while there's news that Bin Laden is dying on the same day. Yea, they know how to get the bad economy off the front page. Rove working a $250mil 527 from the RepubliCon hardliner-base, and Obama is bashed for telling the truth, that he's up against this machine, which will do ANYTHING to stay in power.

[Eagle-Chief]

J.K. (Jason) - inflation has not killed the stock market YET, but just wait, Mister. In fact, inflation could kill the entire U.S. economy, and maybe the U.S. as a nation, if (hyper) inflation turns into civil chaos and rioting due to people not being able to buy food to feed their families.
In addition, inflation robs us all of our wealth. We save for our retirement and our childrens' college education, but inflation makes mincemeat out of our savings, thereby reducing our standard of living.
Inflation is a GRAVE DANGER to both individuals and a nation.