Saturday, October 25, 2008

More On The Effects Of The Surging Monetary Base

Recently, the U.S. monetary base has increased in a unprecedented way. As is illustrated by the chart below, the monetary base has increased more in the last few weeks, than in the preceding 5 years.

As I've noted before, the monetary base in itself has no impact on economic activity. It can however have an indirect impact if it causes money supply to increase. The question then is to what extent money supply will increase because of this. I discussed that issue a few weeks before, and that discussion still largely holds.

However, the point could be made that although MZM rose the latest week, it is still down over the last few weeks and months, so that so far the deflationary effects of the financial distress have been greater than the inflationary effects of the surge in the monetary base. However, that may not necessarily hold, so we should watch the coming releases to see if the latest week's up tick was just a temporary aberation or the beginning of a new trend. If it is the latter, then the combined stock- and commodity bear market may come to an end.

A second point that could be added is that while the increase in the monetary base may perhaps prove to be inflationary, there is actually a good reason to believe that the bank reserve part of the monetary base will be permanently higher relative to deposits (meaning that the monetary base will be permanently higher relative to the money supply). The reason for that is that the Fed since October 1 has started to pay interest on the deposits that banks have at the Fed (bank reserves consists of the cash in vaults and ATM's that banks have plus their deposits at the Fed). Before this change, banks had a strong incentive to minimize reserves because reserves represented a opportunity cost in lost interest income compared to the alternative of lending them out or investing in money markets. Now that the Fed is paying interest, that incentive is far weaker. And given the fact that a deposit at the Fed represents almost the ultimate safe haven, banks in these times of high risk aversion increasingly view that as a attractive option compared to money markets or lending. The result is that the increase in bank reserves (and therefore also the monetary base, which consists of bank reserves plus currency in circulation) will not increase money supply to the same extent as usual.


Anonymous Anonymous said...

Are you also of the opinion that gold and particularly the extremely undervalued gold stocks have a potential double over the next year? Reason: The monetary expansion all over the world?


8:57 PM  
Blogger Aragon said...

M1 is expanding YOY over 10 %, so we all should expect that Mish will change his mind about deflation (if he still thinks that M1 is "the money aggregate").

I am holding my breath waiting that to happen :)

4:48 PM  
Blogger stefankarlsson said...

Göran, for the moment the inflationary effects of the dramatic monetary base increase is counteracted by the factor I described in this post plus general deleveraging. Eventually though, I think monetary inflation will pick up again, and that will certainly cause gold and gold stocks to rise.

8:56 AM  
Anonymous Anonymous said...

I read a view recently that said that gold did not rise in price with credit (stocks and real estate did) and so may not fall as credit falls.

Instead, the argument is that gold varies with narrow money.

Any thoughts on this?


2:29 AM  

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