Jewish World Review Nov. 23, 1999 /14 Kislev, 5760
Y2K Money: Inflationary or Not?
Though few people nowadays ever look at the money supply, recent trends in
one of the key money measures suggests that Y2K-related banking behavior is
undermining Fed policy restraint.
Though the Fed has raised the Fed funds rate three times since late June,
liquidity conditions appear to be significantly easier today than was the
case six months ago. The adjusted monetary base, a high-powered liquidity
measure published weekly by the St. Louis Fed, is exploding.
Since June, the level of the monetary base has increased $30 billion,
calculating to a 13.1% annual rate of growth. Over the prior six months base
growth was a more moderate 7.9% annually. During the past three months base
growth has been even faster, nearly 16% at an annual rate.
The monetary base represents net changes in the consolidated balance
sheet of the Federal Reserve System. Like the balance sheet of any bank,
expansion in the Fed's consolidated statement indicates an easy credit
policy. A shrinking balance sheet shows a tight policy.
The monetary base therefore represents the true supply of dollars, or
high-powered money, created by the Fed. This Fed credit provides the raw
fuel for bank deposit and loan expansion in the commercial banking system.
On the asset side of the Fed's balance sheet, the principal components of
the base -- net purchases of U.S. Treasury securities and loans to member
banks -- are controlled by the Fed through open market operations and
discount window loan policy. This is the source of base money.
On the liability side of the balance sheet are member bank reserves,
vault cash and currency held by the public. These are the uses of base
So what's ballooning the base? Vault cash, which has increased
enormously over the past half-year. Why? Well, you probably guessed it.
Banks are stocking up on vault cash for precautionary reasons to guard
against possible turn-of-the-year Y2K-related currency demands by the public.
This has a reserve adding effect from the liability (uses) side of the
Perhaps banks are selling Treasury bills from their own portfolios, then
depositing the proceeds in their vaults. However, despite three rate hikes,
rapid monetary base growth shows that the Fed is still accommodating
increased bank demands for higher vault cash.
So, the net effect is that monetary base growth is soaring even though
stated Fed policy is aiming for liquidity restraint. Y2K-defensive actions
by the banking sector are overwhelming the Fed's tightening moves.
Another way to measure this is by looking directly at bank reserves held
by domestic depository institutions. Adjusted reserves, which represent the
difference between the monetary base and currency in circulation, and is also
published weekly by the St. Louis Fed, have increased at a 15% annual rate
since June, and an annualized 53% pace over the past few months. In other
words, plenty of new liquidity.
Fortunately, there is no noticeable pick-up in the growth of currency in
circulation, which reflects both international and domestic dollar demand.
Currency continues to rise at the 10% trend rate that has prevailed in recent
years. So the increase in vault cash has not generated bigger growth in
demand deposit-type spendable money.
While base money is soaring, transactional deposit-type money growth is
actually slowing. MZM (money zero maturity, which includes M1 plus
institutional and retail money market funds, less small time deposits) has
eased to 7% annual growth over the past six months from 13% during the prior
six month period. M2 growth has slowed to 5% growth over the recent half
year, from nearly 10% earlier.
Measures such as MZM and M2 (or M3, which has also slowed) represent the
economy's transactions demand for money. Rising money growth indicates a
strong economy, falling money growth suggests a slower economy.
Neither trend tells us much about inflation. Neither the base alone, nor
M2 alone, nor any M alone, is particularly helpful in forecasting inflation.
If, however, base growth (money supply) exceed MZM or M2 growth (money
demand), then the "excess money" effect usually foreshadows higher future
inflation. In other words, it's the interaction of money supply and demand
that is most useful for inflation forecasting.
Since June, gold has increased by a net of 16%, Treasury bond rates have
increased by the net of roughly 35 basis points, the dollar index has lost
about 3%, and the CRB has increased about 6%. Oil prices have increased 39%,
pushing the year-to-year CPI rate from 2.0% to 2.6%. So there are signs that
excess base money has increased current and expected future inflation.
That said, let's not forget that excess base money arising from the bulge
in vault cash is a temporary issue, not a permanent inflation problem. Call
it Y2K money.
In all likelihood, by February or March the Y2K-linked stocking of vault cash
will be reversed, and the excess of base growth over money growth will
evaporate. So, hopefully, Y2K money will not prove to be inflationary. But
this must be watched closely.
Foreign capital inflows to the U.S. must also be watched closely. There
is a view in the marketplace that investors from Asia, Latin America and
elsewhere will seek a haven of Y2K safety by temporarily parking their money
in U.S. dollars and dollar deposits. This too could increase the monetary
Hopefully, then, the important money supply message is not the temporary
inflationary excess in base money, which will probably disappear by
mid-winter. Instead, the slowdown in transactional money demand measures
such as MZM, M2 and M3 may be capturing a future softening of consumer
spending and nominal GDP growth. If so, then Fed Phillips curvers who obsess
that too many people are working, producing and spending may be less inclined
to tighten policy next year.
Now, one final thought on the money supply measures. Money still
matters, but reported money flows no longer have the informational content
they once did. Technology innovations, financial deregulation, reporting
difficulties and globalization have all subtracted from the meaning and the
accuracy of the Fed's money figures. (Just as these same issues have reduced
the meaning of the national income account's GDP estimates.)
Then there's the Internet and the age of electronic money. In a
wonderful book recently written by Washington economist Richard W. Rahn,
entitled "The End of Money and the Struggle for Financial Privacy," the
author makes a strong case that the public's demand for government-issued
currency is on a long-lasting trend decline.
Smart cards, debit cards, money management accounts, and stock market
mutual funds with check-writing privileges, all cleared through electronic
Internet transfer payment systems, are replacing the public's traditional
demand for Fed-influenced currency and deposit volume.
Also, previously illiquid assets and loans can be pooled and securitized
into liquid bond-type instruments that can quickly be made liquid and turned
into money. Large companies, of course, have long directly issued their own
commercial paper, another form of credit that can quickly be converted into
So electronic "money" and bond market "money" implies that the private
sector economy is engaging in money-creating practices with or without help
from the Fed. Once again, the Internet is more important that the Fed.
Rather than money supply numbers, real world market prices such as gold,
dollar exchange rates, and Treasury bond rates and spreads are better
indicators of excess money, money value and future inflation.
But money still matters, though you wouldn't know it from recent Fed
policy announcements. Inflation is a monetary phenomenon. Right now the Y2K
threat is affecting money.
More to be
JWR contributor Lawrence Kudlow is chief economist for Schroder & Co. Inc and CNBC. He is the author of American Abundance: The New Economic & Moral Prosperity. Send your comments about his column by clicking here.
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©1999, Lawrence Kudlow