Money Supply Update (Week Ending 27 January, 2017)

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Summary

Changes in money supply growth rate is an important indicator for the stock market, asset prices, and economic developments in general.

An accurate definition of money supply is required to analyse money supply developments. In this article, I present such a definition of money.

Bank credit growth, an important driver of money supply, appears to have peaked in September last year. This could be bad news for stocks in 2017.

Changes in money supply affect not only prices in general, but also relative prices and economic developments, including interest rates and asset prices. Perhaps of greatest importance, changes in money supply create the business cycle.

Money supply, or the quantity of money in an economy, also has an impact on any economic aggregate stated in money terms, such as GDP (real and nominal) and its components, and stock market indices. Additionally, it affects real economic developments through the influence it wields on the allocation of scarce resources. For example, if banks increase mortgage lending and lower the interest rates charged, more real resources (land, labour, capital) will likely be allocated to the property sector than otherwise.

Given the effects money supply has on economic developments, it is a bit of a conundrum that many investors and analysts pay little or no attention to changes therein.

Money is created through two main paths: 1) banks extending credit to the non-bank public (NBP), which consists of the loans issued and the securities bought by banks, and 2) central banks buying securities ("monetise debt") from the NBP. The NBP here includes the government.

Conversely, money is destroyed whenever banks contract the amount of credit available to the NBP and whenever central banks sell securities to the NBP.

Money supply therefore increases whenever banks extend credit to the NBP and central banks monetise debt, and declines when banks contract credit and central banks sell securities to the NBP. Note that securities and loan transactions between banks and central banks affect the monetary base but not money supply, at least not directly.

A feature of the elastic money supply (soft currencies) employed today is that the quantity of money constantly increases at a high rate. In contrast, a largely inelastic currency (hard currencies), such as money backed by gold, would only increase relatively modestly over time. It is not the absolute amount of money per se that matters to economic developments. Instead, it is the rate of change in money supply that does, of which the business cycle is of great importance. That is why investors, economic pundits, and any student of economic developments ought to include monetary developments in their analysis.

In general, an expanding growth rate pushes interest rates down and many asset prices up, while a declining growth rate may trigger an economic reaction as the value of money increases relative to, for example, asset prices (I explain in detail why here). This is a primary reason investors and asset managers should pay close attention to changes in the growth rate of bank credit and the money supply, in addition to monetary policy announcements.

But in order to follow and analyse changes in money supply, a proper definition of money is required. Over the years, there have been some debate about the proper way to define money supply. This debate centres on the broader components of money supply, as there is no debate that the most liquid components, such as currency and demand deposits, should be included.

As a response to this debate, Austrian school economists Murray N. Rothbard and Joseph T. Salerno responded by compiling a measure of money supply "... that is consistent with the theoretical definition of money as the general medium of exchange in society" and which was "... based on the definition of money [in the broader sense] as originally formulated by Ludwig von Mises in his book The Theory of Money and Credit" (from here). This Austrian school definition of money supply is better known as Austrian True Money Supply, or simply as True Money Supply (TMS).

A distinguishing feature of whether an item should be counted as money, according to Rothbard and Salerno, is if it serves as the final means of payment in all transactions. The use of credit cards illustrates this point. When payments are made with a credit card, the debt is not finally discharged until money is transferred from the bank account of the credit card holder to the credit card issuer. The credit card transaction is hence just an intermediary transaction, while money transferred from the bank account is the final payment. Therefore, credit card balances are not counted as part of TMS, while cash in the bank account is.

A second test for including items in TMS is that they should be instantly redeemable, par value claims to cash. For example, large time deposits do not qualify to be included in TMS, since they are not par value claims to immediately available money. Why? For the simple reason they are time liabilities not payable by the issuing institution before maturity. It could be possible to draw on them immediately, but this would come with a financial penalty. In a similar fashion, small time deposits are excluded from TMS because they "... involve loans by the public to banks and thrifts" (see Rothbard/Salerno link above). Also, retail money funds are not money, as they pass neither of the two tests.

Based on these two tests described above, TMS consists of the following components, all of which can be downloaded individually from the Federal Reserve website on a monthly basis (items are hyperlinked so you can click for a closer look at each):

The first four of these components are also included in the widely cited Federal Reserve definition of a broader measure of money supply - M2 money supply - while the last four are not included in any of the money supply aggregates reported by the Federal Reserve. TMS hence includes money balances held by the government and official institutions, while the official definitions of money supply do not.

The reasons these government/official institution money balances are included in TMS are straightforward. First of all, money held by government institutions can be just as readily spent as money held by the non-bank public. Secondly, these balances pass the two tests of what should be defined as money.

As they did not pass the two tests described above, travelers checks, small time deposits and retail money funds - all included in the M2 aggregate - are excluded from TMS. Large time deposits are not included either for reasons mentioned above.

We see, therefore, that the main difference between the frequently cited M2 money supply and the lesser-known TMS is that the former includes small time deposits and retail money funds, while the latter excludes both. Additionally, TMS includes balances held by government institutions, while M2 money supply does not.

For reasons already mentioned, TMS is superior to M2, as it applies a precise definition of money. Naturally, there is a close correlation between the two, as both count currency, demand and other checkable deposits and savings deposits as part of money supply. These items make up the bulk of money supply in the broader sense, no matter how it is defined. For example, at the time of writing, these items make up about 88% of M2 money supply and 96% of TMS. Given the dominance of these items, M2 money supply is useful as a measure of monetary inflation. But since TMS is superior as a definition of money supply, and as significant differences can occur between the two at times, especially with respect to the growth rate (which is more important than the absolute quantity of money), TMS should be the monetary aggregate of choice. Today, this is more true than in a long time, since Treasury deposits with the Federal Reserve have grown rapidly in recent years.

Following the completion of QE3 towards the end of 2014, money supply growth in the U.S. has been driven by rapid increases in bank credit. The chart below shows the y/y percentage changes in the two series.

The bank credit and money supply growth rates have declined more or less consistently since September and October last year. The primary driver of bank credit is loan growth, since it typically makes up more than 73% of bank credit, while securities make up the rest. The drop in bank credit from more than 8% in September to just above 6% today was hence due to a drop in the growth rate of lending (though securities portfolios have decreased as well).

Bank lending growth will therefore be key to what happens with the stock market and other asset prices in 2017. If the above is an early indication that the credit cycle has peaked, the money supply growth rate will decline going forward, unless the Federal Reserve intervenes. This would be bad news for stocks, which have benefited tremendously from the low interest rates and rapid expansion of money supply since 2009.

Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.