Money Supply Comes Alive: Can the Economy Be Far Behind?

by: Arnold Landy

Money growth is starting to accelerate and that bodes well for the economy. The stock market has been in a funk all year. At the same time, slowing economic growth and fears of deflation have pushed the yield on the 10- year Treasury Note below 3 %.

Throughout the recent financial panic the Federal Reserve acted creatively to support and liquefy the credit system. Bank reserves have skyrocketed, but most of that money remains contained within the banking system, as bank lending has continued to contract. Since bank lending is the primary and most powerful mechanism by which the Fed expands money, its steady contraction has caused the M2 money supply growth rate to decline steadily over the past year and a half. As M2 growth has shrunk, inflation has done the same, and extending the trend has re-awakened fears of deflation and depression.

However, in the last couple of months, growth in M2 money suddenly has begun to accelerate. After many months of very low or negative growth, M2 has now risen at a 9.2% annual rate over the most recent two month period. The spurt has lifted year-over-year growth to 1.7%, still sub-par, but rising. This injection of liquidity can have positive outcomes as it spills over into moderate price increases which can boost demand for goods and services, as buyers act to beat price increases. Deflation, on the other hand, or the fear of deflation, reduces demand as buyers postpone purchases, awaiting price cuts.

It is impossible to tell where renewed inflation will be noticeable, but it certainly would be a welcome sign were it to affect the housing industry. It is also possible that the recent kick-up in M2 is a sign of a loosening of bank credit. If so, we should soon see that reflected in Fed data on bank lending.

The bottom line, here, is that the uptick in M2 growth, if it continues, should end fears of deflation. Two months does not make a trend and the Fed could reverse course in an instant. But, to the extent that this may be an early sign of increased liquidity and, possibly, bank lending, the implications are bullish for stock prices and renewed growth in our economy.

One caveat: income investors will have to keep a wary eye on inflation as bond yields begin their long anticipated march upward, providing higher income, along with declining values for existing bonds.

Disclosure: No positions