Thursday, October 16, 2008

Monetary Conditions Turn Deflationary

This evening's statistics on U.S. monetary statistics show that MZM fell sharply in the week to October 6, from $8693.3 billion to $8638.6 billion (My own calculations based on numbers available here. To calculate MZM, you subtract small time deposits from M2 and then add Institutional Money Funds). That's a decline of more than 0.6% in a week. It is now down 1.2% from its peak in July.

Even M1 and M2 fell back last week, though they (particularly M1) are unlike MZM still up significantly compared to late July.

This provides an explanation of the massive combined stock- and commodity price sell-off in recent weeks. As long as this monetary contraction continues, we will likely see a continued bear market in stocks and commodities.

This decline has happened despite the record fast expansion of the monetary base created by the Fed's various schemes to prop up the banking system. It thus seems that at least for now, the inflationary effects of the Fed's various schemes have been overwhelmed by the deflationary effects of the increased risk premiums created by the recent financial distress.

One thing interesting to note is that even as the quantity of deposit money is declining, traditional paper and metal money (aka cash aka currency in circulation) is increasing at a record fast pace, being up nearly $10 billion or 1.25% in 3 weeks. This mirrors the development during the Great Depression when currency in circulation increased rapidly even as overall money supply fell fast, as popular mistrust in banks caused people to withdraw their deposit money and hold them as notes and coins. These numbers indicate a similar development (although so far much less dramatic, but that might change).


Blogger goo8734 said...

Is there direct evidence that people are actually holding currency instead of depositing it into banks? I would think that with all the deposit insurance that wouldn't be happening.

Or are banks just increasing their reserves with the federal reserve?

12:08 AM  
Anonymous Anonymous said...

Stephan- i think were on the same page when it comes to assessing this current economic debaucle. when u say mzm, do you mean m3? since they no longer publish it? take a look at my economics category on

3:46 AM  
Blogger Robert Wenzel said...


Welcome to the club, but I think this could have been detected in July--before the market went into nosedive. In plenty of time to get out of the stock market.

See for example, my comment to your post in July:

4:33 AM  
Blogger stefankarlsson said...

Goo8734: These statistics are evidence of that. They show people hold more paper money and less deposit money.

Anonymous: No I mean MZM which is a narrower money supply definition than M3 as it does not include time deposits (or repurchase agreements or eurodollars).

Robert, I have been bearish on the stock market for a long time, already last year based on the fact that it was highly overvalued in a historical perspective and the recession I saw coming. And I did note that money supply growth had become stagnant already in July. I did however admittedly become (short term) bearish on commodities a lot later as I wasn't sure that the slowdown in money supply growth would last. When it became clear it would I changed my mind on that.

The significance of this news is that it has gone from growing very slowly to contracting significantly.

8:48 AM  
Blogger Robert Wenzel said...

Hi Stefan,

I don't want to be difficult about this. But I just did my money supply numbers for this week. I look at M2 and the decline in money supply seems to have reversed. Based on 3-month M2 annualized, the money supply decline seems to have bottomed in mis-September at a growth rate of 1.5%.

The latest numbers a show a near tripling in the growth rates at 4.1%, from the low of three weeks back.

If this continues, those forecasting a long recession are in for a big surprise. Inflation should be the real fear.

2:51 PM  
Blogger Celal Birader said...

Looks like more hedge fund de-leveraging wreaking havoc on the stock market

3:18 PM  
Anonymous bill said...

i read something the other day that made a lot of sense.

the fed knows they have to get ride of the mailinvestment and they know too much printing will cause a lot of inflation and too little will cause massive deflation, and its a very small needle to thread.

so they are going to be going each way for a long time to try and get everything out of the system.

catch is they will not be able to do it so who knows which way they will fail. but if they fail the deflationary end IMO they will likely over compensate and go hyperinflationary.

4:42 PM  
Blogger stefankarlsson said...

Well, Robert, I disagree with you on the issue of whether M2 is better than MZM. Time will tell how long or deflationary/inflationary the downturn will be (and for that matter how M2 or MZM will develop) but what should be noted already now is that M2 rose significantly just before the recent sharp decline in stocks and commodities, while MZM fell during that period.

10:35 PM  
Blogger Robert Wenzel said...


How can you possibly say that M2 was climbing before the commodity and stock market crash?

In March, it showed annualized growth of 12.5%, by September it was down to 1.5% annualized growth.

And, again, I commented on your post here:

back in July that money growth was slowing.

10:52 PM  
Blogger stefankarlsson said...

Robert, in the first week of October the stock market fell nearly 20% in a week, and most commodities developed similarly. In the 3 weeks between September 15 and October 6 , M2 rose more than 2% (from $7680.8 billion to $7828 billion). I think you can calculate yourself the annualized growth rate a 2% increase during 3 weeks imply.

11:30 PM  
Anonymous Anonymous said...

I have money at home and I have advised all my friends to do the same. (UK)

12:01 AM  
Blogger Robert Wenzel said...


There is no way there is a week to week correlation between money supply and the stock market and commodities. It doesn't exist for M2, MZM ot TMS.

Over months and years, yes. Between weeks no. Indeed, in your reply to me back in July you said:

Robert, I look at MZM. MZM growth have slowed significantly too, although it is still positive, and I wouldn't make that much from such a short term trend

The fact of the matter is that money supply growth [M2] COLLAPSED after March and continued in a downward spiral until mid_September. That is what has caused the collapse in the stock market and commodities.

1:12 AM  
Blogger stefankarlsson said...

Robert, I don't know why you're so obsessed with that comment as it is irrelevant in this context. All I said there was that I didn't think the significant slowdown in MZM growth would continue. As it turned out, that expectation was wrong and not only did it not rise again, but it fell further and starting late July it fell below zero and in recent weeks it has been significantly below zero.
That correlates nicely with the recent massive decline in almost all markets, including the stock market.

You say there is no correlation on a weekly basis between money supply and stock markets. That is true in one sense, but in that sense there is no correlation on a monthly or yearly basis either. For example, in 2001, both M2 and MZM increased sharply, but the stock market fell sharply. The main reason why there is no such correlation is that the increase in money supply can go to other asset classes (such as property and commodities). Exactly what prices money supply bids up depends on the economic context of that increase, and for that reason you're not going to see any perfect correlation between any money supply aggregate or the prices of some particular asset class, whether on a weekly, monthly or yearly basis. Which is why I was bearish on the stock market even when MZM increased rapidly.

However, it is the case that money supply changes will ceteris paribus move asset price changes in the same direction and since asset prices (at least stocks and commodities, house prices are arguably more sticky) are very flexible, there won't be much time lag. And I think that one of the most important reasons why the price of all assets decline now.

11:13 AM  
Blogger Robert Wenzel said...

I think you are missing a key factor that does cause a time lag when money supply is slowing versus when money supply increases.

A halt in money supply growth itself will not drop the stock market. What must occur is the re-adjustment in the consumption-savings ratio. This is where the time factor comes in.

1:19 PM  
Blogger stefankarlsson said...

Robert, an increased money supply cause an immediate increase in funding ("forced savings" as some have put it) for whatever it is used to bid up. Because of this, the effect on prices should be apparent almost immediately provided prices are fully flexible, which they certainly are in the case of the stock market.

11:06 PM  

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