Wednesday, June 20, 2012

What If We Had A Money Printing Party and No One Came?

The FOMC meeting began yesterday and will announce a decision today.  As I and NDD have noted, the underlying data of the US economy for the last few months has been weakening.  As such, it seems appropriate to think the Fed may act in some capacity, probably with some type of asset purchase program.  Some will argue this is not warranted, or, more importantly, that this is going to lead to an inflationary spike.  Nothing could be further from the truth, as I explain below.

One of the primary complaints about the Fed's action of increasing their balance sheet is that the increase in money will lead to inflation.  In essence, an increase in the supply of money inherently devalues it (increased supply = lower value).  However, this theory runs into two problems.  First, the money has to get into circulation and then, second, be exchanged.  Put another way, if the Fed prints the money and then the banks don't lend it and consumers don't spend it, the devaluation of the currency can't occur.  That lack of transmission of the Fed's policy is exactly what is occurring right now.

First, let's look at the YOY percentage change in monetary aggregates:

The three charts show the year over year percentage change in M1, MZM and M2, respectively.  All three show that money is flooding the system: M1 is increasing at about a 15% YOY clip, MZM at 8.5% and M2 at about 9.3%;  So -- why has there been no commensurate increase in inflation?

There are two answers to that.  First, the "money printing" is getting stopped at the banks.  The Fed is purchasing assets from financial intermediaries and giving them money in return.  But lending has been very weak during this expansion.

Above is a chart of total loans and leases at commercial banks.  Notice that the figure is right at pre-recession heights -- and this is after almost two years of quantitative easing.  And while we've seen an increase over the last few years, it is hardly a strong rise.  Let's look at the chart in logarithmic scale, which further highlights the situation:

The slope of the curve for the latest expansion (rise/run) is very low.  It's slightly above the level seen after the 1990 recession and the 2000 recession, but below that seen over the last 40 years.  Put another way, loans just aren't being made, meaning the "money printing" is not being transmitted through the financial intermediary system.

And the multi-decade low in velocity tells us that consumers aren't spending what money is getting into the economy, but instead hoarding cash:

The velocity of M1 (top chart), MZM (middle chart) and M2 (bottom chart) all show that the speed at which money moves through the economy is at or near multi-decade lows.

Let's put these two pieces of data together.  First, while the Fed is technically flooding the system with money, this is not leading to inflation as there has been no respective increase in lending.  As such, inflation cannot be transmitted into the system.  And what money is getting into the system is being hoarded by consumers rather than being spent.

So, the complaints that "money printing will lead to inflation and devaluation of the dollar (read: Ron Paul acolytes) are unfounded.