Money Printing Continues Apace
The global race to debase, in an ominous parallel to the 'beggar-thy-neighbor' policies of the 1930's depression, continues at full blast. This was underscored again on December 28, when Japan's new finance minster Taro Aso told reporters that Japan refuses to be 'lectured' by others on the merits of its latest plan to debase the yen.
“Japanese purchases of foreign bonds to weaken the yen may become more likely as the nation rejects trading partners’ rights to criticize its currency policies.
“Foreign countries have no right to lecture us,” Finance Minister Taro Aso told reporters at a briefing in Tokyo on Dec. 28. He said that the U.S. should have a stronger dollar and questioned whether major Group of 20 nations had stuck to pledges from 2009 to avoid competitive currency devaluations.
Japan’s new Prime Minister Shinzo Abe may accept trade friction as a cost of spurring growth and countering deflation through a looser monetary policy and weaker yen. The currency is set to complete its biggest annual decline in seven years after Abe’s Liberal Democratic Party secured a landslide victory in this month’s lower-house election. During his campaign, Abe said foreign-bond purchases were a possible monetary tool.
“The LDP wants to boost stock prices before the upper- house election in July next year, and the easiest option for them is to weaken the currency,” said Satoshi Okagawa, a senior global-markets analyst in Singapore at Sumitomo Mitsui Banking Corp., a unit of Japan’s second-biggest bank by market value. “The explicit policy to weaken the yen is likely to upset the U.S. And China.”
As you will see further below, the Bank of Japan so far continues to fail to actually increase the supply of yen by a percentage large enough to make a difference (which is of course a good thing). However, the above highlights several important fundamental points: Aso is correct when he states that others have not stuck with their pledges to avoid competitive devaluations. They really do have 'no right to lecture Japan' based on that. Furthermore, Shinzo Abe appears to have correctly divined that there is a connection between the social mood, stock prices and the chances of incumbents to get reelected. Since there is at the moment an inverse correlation between the yen and the Nikkei, mostly driven by clueless foreign investors, it is understandable that he is targeting the yen's exchange value in his endeavor to improve his party's chances at the polls.
Whatever the specific reasons may be, everybody is at it; all protestations to the contrary, the major central banks of the largest developed market currency areas are all trying to devalue the money they issue. This is being done in ever greater gobs, in spite of the fact that the policy has predictably failed to deliver the hoped for results for many years running, which is bound to continue. Unfortunately, in spite of both the theoretical and empirical evidence documenting this failure, the faith that central planning of money and interest rates will somehow 'work' has rarely been more deeply ingrained than today. It is a bit like living in a nightmare in which logic and rational thought have been suspended.
Attempting to print the world back to prosperity: Ben Bernanke, Mario Draghi, Maasaki Shirakawa and Mervyn King.
(Photo credit: Gerald Herbert)
On the Road to Nowhere
Below is a chart that compares the pace of monetary inflation in the industrialized nations. As can be seen, the Bernanke Fed so far continues to beat everyone else in the inflation department. For a thorough discussion of the money measure TMS ('true money supply') and how it is defined, we want to point readers to this excellent overview by Michael Pollaro (who is also the creator of many of the charts presented below).
Year-on-year growth of the true money supply in the US (10.6%), the euro area (6.1%), Japan (3.2%) and the UK (3.2%) – click for better resolution.
As can be seen, since the 2008 financial crisis, the Fed's direct monetization of government debt and mortgage backed bonds has been most effective in actually creating consistently high money supply growth. We suspect that this is in large part due to the fact that the Fed buys a lot of securities not only from banks, but also from non-banks. When the central bank purchases securities with newly created money from non-banks, it increases the amount of deposit money in the system concurrently with increasing bank reserves. If it were solely buying from banks, bank reserves would increase, but the money supply would only increase if banks were then pyramiding additional credit atop their increased reserves. We suspect that the ECB and the Bank of England had trouble keeping the pace of monetary inflation high because they bought securities mainly from banks that in turn were eager to deleverage.
Let us first take a look at US money supply growth. So far, 'QE3' and 'QE4' have not yet ignited a strong acceleration in bank reserve and money supply growth. However, one must be aware that this is mainly due to technicalities. For one thing, the Fed's purchases of mortgage-backed securities are subject to a large settlement lag. The first purchases undertaken in the course of 'QE3' (the MBS purchase program) only settled in mid November. Concurrently the treasury drew down $100 billion in deposits it held with the Fed. Since these are part of the money supply, growth in narrow money TMS-1 was negative for the month of November, and growth in TMS-2 was slower than it would have been otherwise. We expect this effect to be temporary; likewise, the most recent data captured in the US money supply growth charts include what is probably a seasonal decline in demand deposits, offset by a much larger increase in savings deposits (the latter are part of TMS-2, but not TMS-1). Currency in circulation continues to grow at a strong pace as well, up 8.9% year-on-year. Moreover, the recent sharp increase in 'securities held outright' by the Fed shows that the new inflationary program is now well on its way.
Currency in circulation is at a new record high – click for better resolution.
Fed credit – securities held outright have also reached a new record high – click for better resolution.
The monetary base is approaching the upper end of its recent sideways channel. It will likely soon break out to new highs, similar to what was seen on the occasion of the first two 'QE' iterations – click for better resolution.
It is instructive to look at a long term chart of the US money supply. We keep hearing that there 'is no inflation', but money supply growth in the inflationary 1970's didn't look much different from today's – in fact, if anything, it was a bit less pronounced. This highlights the problem that attends attempts to measure inflation by calculating the mythical 'general level of prices'. We know for an incontrovertible fact that if the money supply increases, prices are going to be higher than they would have been absent such an increase. However, the purchasing power of money does not only depend on its supply. Both an increase in economic productivity and an increase in the demand for holding cash balances can mask the effects of inflationary policy on prices. This is usually when the most dangerous economic imbalances tend to build up, as policymakers and mainstream economists are lulled into a false sense of security by the fact that CPI appears to be tame.
A long term chart of the broad US money supply TMS-2 with quarterly and annual growth rates. Money supply growth since the year 2000 appears to be stronger on average than during the 'stagflation' decade of the 1970s – click for better resolution.
The fact that money is not neutral and that there is therefore no linear relationship between the money supply and prices doesn't receive the attention it deserves. This is not really a big surprise, since if any attention were focused on this matter, one could not possibly skirt the inescapable conclusion that increases in the money supply enrich some groups in society at the expense of others. The strata of society that are hurt the most by inflationary policy are precisely the ones the policy is allegedly designed to 'help'. Exposing this lie can potentially prove dangerous to a mainstream economist's career.
Is there some way of measuring the 'success' of all this money printing? Since the year 2000, the US true money supply TMS-2 has more than tripled. If the performance of the economy and the action in the stock market since then are any indication, the policy has evidently been leading us down the garden path.
Of course we would not even need empirical evidence of this sort to come to this conclusion. We are mainly mentioning it because the perpetrators of the policy are positivists who do pretend that they rely on empirical evidence. The models they use for guiding their decisions are based on statistical data after all. Apparently any evidence that contradicts their preconceived notions of what should 'work' is destined to be ignored.
In the time period between the two red arrows, the US money supply TMS-2 has grown by 214%. Stocks have gone nowhere in this time amid extreme volatility, while the economy has suffered two recessions and is obviously in worse shape today than prior to the acceleration in money printing – click for better resolution.
2013 Outlook for US Monetary Conditions
2013 is going to be an interesting year. We have already commented on the seeming inability of 'QE inf' (3 and 4 combined) to move the stock market higher thus far. While by no means conclusive yet, this may constitute a warning sign: if the economy's pool of real funding is damaged beyond a certain threshold, then additional free liquidity may no longer flow into stocks.
What is also going to be interesting is how the Fed's new economic 'targets' are going to play into the conduct of policy in 2013, especially considering that this year's FOMC board is going to be even more dovish in terms of its voting members than the outgoing one. While the lone hawk and serial dissenter Jeffrey Lacker will be gone, the ultra-dovish Eric Rosengren from the Boston Fed and Charles Evans from the Chicago Fed will both have a vote this year. We wonder what will actually happen if the newly announced unemployment and 'inflation' rate targets are actually reached. We wouldn't be surprised if some new rationalization were to emerge then so as to keep the extremely loose monetary policy stance in place. However, this is a bridge we will cross if and when we get there. As it were, there are numerous indications that the economy may 'unexpectedly' weaken in spite of the current round of heavy monetary pumping. For one thing, three of four major coincident economic indicators the ECRI institute employs in attempting to forecast recessions have already peaked in mid 2012.
With the exception of employment, the major coincident economic indicators ECRI watches have peaked in mid 2012 – click for better resolution.
Indicators we are inter alia keeping an eye on are the various ratios of spending on capital goods production versus consumer goods production. The chart below depicts the ratio of spending on business equipment versus non-durable consumer goods production. This is an attempt to roughly gauge the effects of monetary policy on the economy's production structure. As might be expected, the Fed's loose monetary policy has drawn factors of production away from lower order to higher order goods production. The problem with this is that all economic activity must ultimately be funded by real resources. Money as such cannot fund production: it merely serves as a medium of exchange. However, when the money supply grows and interest rates are artificially suppressed by central bank intervention, it certainly appears as though there were more savings available than there actually are. If the long-range investment projects in higher order stages of production that have been initiated as a result cannot be funded, they will eventually falter and will have to be abandoned, regardless of how much money the Fed prints.
A large shift in production away from lower order to higher order goods due to credit expansion will eventually bring about a production structure that ties up more consumer goods than it releases – and this is ipso facto not a sustainable condition. A recession eventually becomes unavoidable, even though the precise timing cannot be forecast.
The ratio of spending on business equipment production against spending on non-durable consumer goods production has recently reached a new record high. Note that this ratio tends to peak shortly before recessions begin – click for better resolution.
As an interesting aside to this, we have also constructed an overlay chart that shows the above ratio and the S&P 500 index. A divergence between the two data series is currently in evidence. Usually both the ratio and the SPX tend to reach peaks almost concurrently, with the SPX tending to lead slightly. Recently though a new high in the ratio was not 'confirmed' by a preceding new high in the SPX. We are of course not certain if this is meaningful, but it may well be that it will turn out to be a valuable timing indicator, so we wanted to draw attention to it.
The above ratio compared to the SPX – their recent peaks are diverging relative to the previous two occasions – click for better resolution.
If ECRI is correct – the institute continues to predict a recession and actually thinks its beginning will eventually be backdated by NBER to sometime in 2012 – then we should expect that the Fed will not only fail to begin with the much talked about 'exit' from its non-traditional monetary policy initiatives, but may actually add even further measures to the existing money printing programs. Given the recent new high in the ratio of capital versus consumer goods production, it is definitely conceivable to us that ECRI will turn out to be correct with its forecast.
Monetary Conditions Outlook for the Euro Area
Money supply growth in the euro area as a whole has accelerated all year long and most recently stood at 6.1% year-on-year. The ECB provided the impetus with its LTROs and the promise to engage in the new 'OMT' program ('outright monetary transactions') of government bond purchases in the event Spain or Italy are hitting the wall and apply for a bailout. However, the actual agent of the recently recorded money supply growth is surprisingly the banking system. Outstanding ECB credit and with it covered money substitutes have actually been declining for some time – the growth in the money supply is thus largely owed to growth in uncovered money substitutes, this is to say credit expansion on the part of commercial banks. This is of course quite uneven across the euro area: there is e.g. monetary deflation in Spain and the other peripheral countries that have been hit the worst by the crisis. Currently this appears to be outweighed by credit expansion in the 'core' countries.
Evidently this will only continue as long as confidence improves, i.e., as long as everybody remains convinced that the sovereign debt crisis has been overcome. This faith rests on a very weak foundation, as the peripherals seem highly likely to once again miss their deficit targets in the course of 2013. There will of course not be any reduction in their cumulative debt at all. The criteria set forth by the 'fiscal pact' are going to be increasingly out of reach. Eventually we expect to see that the ECB will go beyond mere words and actually implement the 'OMT' program.
Euro area money supply aggregates – back on a growth path for now – click for better resolution.
Outstanding ECB credit has begun to decline again following the LTROs – click for better resolution.
Below is a chart illustrating the wild volatility in the growth rates of the major euro area money supply components. Evidently, central banking and 'flexible currencies' have not exactly contributed to low volatility in these measures.
Volatility in the growth rates of euro area money supply components. Somehow this is held to be 'better' than the steady small money supply growth we would likely see under a gold standard – click for better resolution.
Monetary Conditions Outlook for Japan – Exercises in Futility
The BoJ has by now grown its outstanding credit considerably, although the total still remains below the 2006 peak. As Japan has been at this for far longer than other central banks (it is already engaged in 'QE5' or 'QE6', depending on how one counts it), the ratio of covered to uncovered money substitutes has long ago inverted in Japan, i.e., there are far more covered than uncovered ones.
In spite of the BoJ's interventions though, money supply growth in Japan remains very low. The banking system has no interest in expanding credit, and we may assume that there are also only very few borrowers willing to add to their debt. Although a sufficiently motivated central bank can always create inflation in a fiat money system, it remains to our mind quite doubtful whether Shinzo Abe's inflationary plans will actually be implemented. For now the recent moves in the yen and the Nikkei rest solely on perceptions, not reality. At the end of September, the year-on-year growth rate of Japan's money TMS stood at 4.2% – by the end of October it had slowed down by a full percentage point to only 3.2%. The culprit is a nearly 60% year-on-year decline in uncovered money substitutes, offset by a 48% increase in covered money substitutes. In other words, Japan's commercial banks are contracting credit and with it the money supply while the BoJ attempts to increase it.
Japan's money supply aggregates TMS and M3 – growth in both is recently slowing down again – click for better resolution.
BoJ credit outstanding is increasing, but has yet to even reach the levels of 2006 – click for better resolution.
It should also be noted here that the recent rally in the Nikkei that coincided with a bout of considerable yen weakness may not be much more than a seasonal phenomenon which we have observed for three years running. The chart below shows that in recent years rallies have tended to begin around October and have subsequently peaked out sometime in March (incidentally the fiscal year end for most corporations in Japan).
The Nikkei, weekly. In the past three years, rallies have begun in October and peaked in March. The beginning of this year's rally was right on time again – click for better resolution.
In short, one must suspect that this year won't turn out to be different. Conversely, if the recent rally were to remain alive beyond the usual March cut-off date, we would be provided with a clue that something more profound is going on. As can be seen below, on a very long term basis the recent rally in the Nikkei doesn't really amount to much yet. Perhaps the forth time will be the charm. Much will of course depend on how stock markets elsewhere in the developed world perform this year. We can imagine a rising Nikkei while the SPX and the core euro area markets either go sideways or move higher, but Japan's stock market is highly unlikely to be able to decouple in the event that these markets should head lower.
As our readers know, we are partial to Japanese stocks long term, based on the idea that they are cheap – in fact, they are cheaper than they appear on the surface, due to Japanese companies understating their profits by means of accelerated depreciation. However, whether the market has turned up for good here remains to be seen.
The Nikkei's long bear market since late 1989 – the recent rally is but a blip on this long term chart. Will it eventually turn out to be something more? – click for better resolution.
One interesting and quite surprising factoid is that while speculators have amassed an extremely large net short position in yen futures, they have so far failed to go net long Nikkei futures. Only very recently have small speculators begun to scramble to cover their shorts on the index, which has likely added fuel to the recent rally. Given the difference in views on the yen and the Nikkei, there may be a chance that the index will at some point cease to be driven by moves in the yen.
Commitments of traders in Nikkei futures – surprisingly, speculators have up until recently held a very large net short position on the index. Over the past few weeks they have begun to cover their positions, adding fuel to the rally (chart via sentimentrader) – click for better resolution.
Will the BoJ follow Shinzo Abe's prescriptions? Probably not as long as the very cautious Maasaki Shirakawa remains its governor. However, in April this year Abe will likely replace Shirakawa with a more dovish governor, so we will have to wait and see what happens thereafter. As we have pointed out a few times already, the JGB market remains doubtful. Should it however become convinced that a more determined inflationary policy is indeed on the way, it will likely very quickly disabuse Mr. Abe of his misconceptions and help him change his mind again. Japan's aging consumers should hope so – they have certainly no use for inflation.
Cautious BoJ governor Shirakawa – his reign at the helm of the central bank will end in April.
(Photo via The Web, source unknown)
Charts by: BigCharts, Michael Pollaro, ECRI, St. Louis Federal Reserve Research
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