We recently received some feedback on our commentary about whether the Central Banks’ behavior is inflationary or deflationary. The following feedback came from a very sharp individual who used to be Director of Research for Moody’s.
“Hi Charlie & Team--Thanks for the great work! I think we will have inflation, then a collapse of the dollar, then declining prices.”
“I do not think you mean deflation. Deflation by definition is declining prices concurrent with monetary restraint. We are not going to have any monetary restraint. But we will have multiple bubbles bursting. That is not deflation. That is simply declining prices resulting from a change in the demand/supply fundamentals for all sorts of assets. People are going to revalue stocks, currencies, lots of assets. But monetary restraint will not be the driver so by definition it is not deflation.”
At this point, perhaps an explanation of some of the terminology we will be using in our response will be helpful. First of all, it should be understood that the world central bankers have been purchasing their own sovereign debt, which in essence is how they increase their balance sheets. Currently this process is going on at an unprecedented pace. In fact, the Fed has expanded their balance sheet by over 4 times and is still purchasing $85 billion of Treasury securities and mortgage backed securities each month. The expansions of the balance sheet assets are essentially an increase in their respective monetary bases.
Next, we will explain why the purchases of this sovereign debt, although it seems to be very inflationary, are actually deflationary. History shows the growth in the money supply has been increasing at a much smaller rate than in the past. The reason for this is the “multiplier” effect as well as the “velocity” of the respective economies. The “multiplier” is the ratio of the monetary base to the money supply and is therefore calculated by dividing the money supply (usually M-2) by the monetary base. The “velocity” (or turnover of the money supply) shows how long individuals and corporations hold onto their money, and from this, we can infer that by holding onto cash they are fearful of a weakening economy. The “velocity” is calculated by dividing the real GDP by the money supply (usually M-2). There are charts attached in our response showing the magnitude of the drops in both the “multiplier” and “velocity”, and indicate that there is a much greater chance of deflation than inflation.
The other phenomenon that is taking place presently is the incredibly strong bull market in stocks driven by the Fed’s policies that are producing incredibly low interest rates. These low rates have driven many institutions and individuals into the stock market due to the illusion that stocks will continue higher as more people invest in them because there is virtually no other investment vehicles producing an adequate return. Sometimes getting close to a zero return is better than getting enticed into risky investments. The distortion of the stock market gains is quite appealing until the deflation we expect actually hits the U.S. economy.
Below is our response to this viewer’s comments:
“We are somewhat on the same page but with different conclusions. We believe that there will be no monetary stimulus by the Fed, but only because no matter how much the Fed increases their balance sheet, there will be low velocity and reduced multipliers of the monetary base. Individuals and corporations who have the credit ratings to warrant the ability to borrow money will refuse to do so, and the people who don’t have strong enough credit ratings will not be able to borrow from the banks. This will produce the deflation that we talk about in our commentaries and “special reports” (as assets decline and debts are defaulted on or paid down). Charlie and Marty”
The elaboration to this response will serve as our “special report” this week. First of all, the first attachment (Global Central Bank Balance Sheet Growth by Ned Davis Research) illustrates just how strongly the balance sheets grew by the Fed, European Central Bank, Bank of Japan, and People’s Bank of China. You can see that all of these balance sheets rose sharply from 2003 until the Great Recession of 2008, and then exploded to the upside again from 2008 to present. (The second attachment—Central Bank Balance Sheet Growth—also by NDR shows how many countries’ balance sheets to GDP are even worse than the U.S.) The way Central Banks around the world expand their balance sheets is by buying government securities of their respective countries. When they buy these securities from banks and other institutions they pay for them by writing a check from the government (in the case of the U.S., it would be a check written by the Treasury Department). Clearly this is a form of “printing money” since these funds add to the monetary base of the U.S. The money used to buy securities from banks is added to their reserves and are available for the banks to lend. This is why the monetary base is referred to as “high powered money” since the banks have the ability to increase the money supply substantially. The reason they can increase the money supply sharply is because we have a fractional banking system (loaning out money at potentially double digit amounts of their reserves). When this takes place, bank deposits and currency increases-- and these are what constitutes M-2. So if banks loan out the new reserves and individuals and corporations decide to borrow more money, M-2 would expand greatly. This would have to look extremely inflationary to most sophisticated analysts, and, in fact, we were also concerned that this could be very inflationary.
However, we were also very much aware of what took place in the Great Depression in the 1930s. Back then the banks became reticent to lend the new “high powered money”, and the corporations and public were afraid to take out new loans. This resulted in a contraction of the “multiplier” and “velocity”. The multiplier effect is the relationship of the monetary base to M-2 (money deposits and currency in circulation). Stated another way, it is the banks’ conversion of reserves into more money—how much more money is the multiplier effect. When the monetary base increases as it has over the past decade (as the Fed increased their balance sheet by over 4 times), and M-2 does not rise in the same proportion as in the past, it is clear that the multiplier had to decline. The multiplier is found by dividing Money (M-2) by the Monetary Base. As you can see in the third attachment (Money Supply and Monetary Base by our favorite source NDR), the “multiplier” of M-2 declined from a range of 8 to 9 from 2000 to 2008 before declining to the present level of 3 due to the effects of the Great Recession. As you can see on the same chart you can also get the multiplier for M-1 and MZM (all forms of money). The 4th attachment, (Japan M-2 Money Supply, Monetary Base, and Multiplier also by NDR), shows Japan’s M-2 multiplier which also dropped from the 13 area when their enormous debt in 1990 led them into a deflationary morass for the past 23 years, to less than 5 presently.
The multiplier is very significant in order to judge whether any country is headed for inflation or deflation, but the “velocity” of money is just as important. The velocity is the turnover of the money created. If the money turns over, with banks’ lending money and more individuals and corporations borrowing money the turnover produces an increase in the GDP of the country. If M-2 increases and the GDP increases by the same amount, the velocity (or turnover) would equal 1.
The velocity is arrived at by dividing GDP by M-2, and if the turnover is great the GDP would rise at a greater rate than the rise in M-2. If the turnover, or velocity, is high the GDP would rise to a greater degree than the M-2 growth (see attachment #5-- Velocity of M-2 Money Stock by the FedRED) due to the greater turnover (of borrowing and lending). As you can see the velocity was stable at just about 1.7 for the past 6 decades (after WW II) before rising to over 2.2 during the dot.com bubble in the late 1990s. After the bursting of the dot.coms the velocity has subsequently broken down below the low of the past 6 decades due to the fear of borrowing and lending generated by the Great Recession.
The evidence of the Multiplier effect and the Velocity declining to levels only seen during tremendous excess debt and debt liquidations (like the Great Depression and Japan), we also have to point out that commodities seem to be breaking down. And that is in the face of all these enormous balance sheet increases by the largest economies in the world that many feel can only produce inflation. The chart (attachment #6) of the CRB Raw Industrial Spot Index (also by NDR) is important to monitor since it peaked at about 690 in late 2010 and is a little more than 525 presently. If this breaks below the upward trend line of about 400 this would almost guarantee a deflationary scenario. And in a deflationary scenario, there is almost no chance that the bull market will continue.
Again, the key to monitoring inflation or deflation is the effect of the multiplier and velocity of the money supply. Multiplier= M2/Monetary Base Velocity= Real GDP /M2 & M2xVel=GDP