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Economic Insights

It just might be. Data suggest that the central bank’s massive liquidity boost may be starting to flow into the broader economy.

It looks as though money is beginning to move.  Both the narrow M1 definition of money and the broader M2 definition1 have accelerated of late, suggesting that perhaps the tremendous amount of liquidity the Federal Reserve has poured into financial markets and onto financial institutions has at last begun to flow into the general economy.  This movement, effectively from Wall Street to Main Street, will, if it persists, cheer businesses large and small, no doubt, and the unemployed.  But the shift also will call Fed policymakers into action in order to secure control of the sea of liquidity they have provided so that it does not lead, as such liquidity flows have historically, to economic overheating and inflationary pressures.  Matters are far from urgent, however, but such a movement, again if it lasts, could present investors with a very different Fed from the one to which they have grown accustomed.  Perhaps the Fed’s new determination to taper the rate of quantitative easing reflects such a response, at least in part.

Accelerating Money Growth
The statistics may be revised, but what the investing public and the Fed have now is a picture of accelerating money growth.   MI money has begun to grow much faster during the latter part of 2013 and into this new year.  After a summer quarter, which saw an annualized M1 growth of barely more than 5%—not much different than the pace of expansion registered by nominal gross national product (GDP)—September saw the pace of M1 expansion jump to  an annualized rate of almost 17%.  Between January and mid- February 2014 (the most recent period for which complete statistics are available), growth averaged more than 25% at an annual rate.2

Since the only way such an M1 acceleration occurs is through a growth in checking accounts, the pattern suggests that perhaps banks and the other financial institutions are finally lending and otherwise moving the ample reserves the Fed has provided for so long.  The implication, then, though only preliminarily, is that the liquidity is flowing to businesses and individuals and so to the general economy.  That conclusion gains some reinforcement from the figures on bank lending, which have jumped from an anemic 1.6% annualized rate of increase last spring and summer to about a 5.0% annual rate of advance during the three months ended in mid-February (the last period for which complete data are available).3 This can hardly be described as a breakout, but it may serve as a harbinger.    

Implications
On its face, the news speaks to the ultimate success of the Fed’s policy of monetary ease.  Since the financial crisis and recession of 2008–09, the Fed has tried to bolster the economy, bringing short-term interest rates down to nearly zero and using three quantitative easing programs to redouble the economic lift by trying directly to depress longer-term bond yields.  Bank reserves exploded in response to this policy, growing at an annualized rate of more than 25% between mid-2009 and into 2013.  So did the so-called monetary base, which adds currency in circulation to the reserves total.  It grew at an annualized rate of more than 17% during that same time.  But great caution among financial institutions and business managers kept lending slow, effectively blocking the huge volume of liquidity from reaching the general economy.  The money measures offered one sign of this blockage.  Though they follow an erratic pattern, these measures grew at a much slower pace, on balance, than either reserves or the monetary base.  Another sign was that bank lending, until very recently, hardly picked up at all.  So little of this liquidity reached people and firms that, on average, some 95% of the reserves held by banks have been in excess of what was required to support their lending and deposits.4    

Now, with the acceleration in money statistics and loans, policymakers might think that the funds at last are flowing where they wanted them to go all along.  Investors who like to extrapolate can point to the change as justification for an expectation of accelerating the nominal and real economy, perhaps toward the faster pace associated with past economic recoveries.  Policymakers who too like to extrapolate might see in this recent picture a need to begin to unwind the support of the past five years in order to keep matters from getting out of hand.  The Fed’s determination to taper the extent of its ongoing and third quantitative easing program may reflect such thinking, among other considerations.   For those investors and policymakers with a very long-term perspective, the trend might raise fears of bubbles, economic overheating, and a generalized inflation, all of which have strong associations with persistent, strong money growth.    

Caveats   
Though the change is noteworthy and should be watched, considerations on several levels leave room for skepticism about its staying power.  One is statistical.  Over this time of disappointing economic recovery, the money figures have shown other periods of acceleration that have then only petered out.  Most recently 2012 saw such a false signal.  During the summer and fall of that year, the M1 category of money jumped from the 6.5% average annualized rate of expansion it had averaged late in 2011 and earlier in 2012 to an annualized growth rate of almost 16%.  But then it slowed again in early 2013.  To be sure, this earlier money surge lacked the confirmation of a parallel acceleration in loan growth, such as exists today.  Back then, overall bank lending grew at less than a 3.0% annualized rate.5 The reinforcement offered by the loan data this time might make this latest flow seem more real and lasting, but still, the past false signal warns that things are not always what they seem and that it would be mistaken to take this latest evidence as an assured trend.

A certain wariness also lies behind the fact that most of what have been muted economic responses to date remain in place.  Throughout this slow recovery, the bruising lessons of the 2008–09 financial crisis and recession have made banks and other financial institutions reluctant to lend, as they have made non-financial businesses reluctant to use credit.  Perhaps, after more than five years, those bitter memories are beginning to fade.  Of late, surveys of senior bank-lending officers suggest a slight easing in their willingness to lend.  But it seems unlikely that such cautions will dissipate quickly.  Meanwhile, the ambiguities and legal threats implicit in the massive and complex Dodd-Frank financial reform legislation remain an unchanged inducement to caution, as they have throughout.  Also, little clarity has come to the Affordable Care Act.  Its uncertainties and potential costs should continue to keep businesses and industry reticent about hiring and expansion and so reluctant to tap the otherwise plentiful and cheap flow of credit provided by the Fed to financial institutions and the financial system.      

Conclusion
Against such a backdrop, investors and policymakers need to take a balanced view.  On the surface, the accelerated flow of money should alert them to the possibility that the underlying financial and economic situation is changing, that at last liquidity is flowing into the economy; that in time it may have a reflection in an accelerated real growth path, with all the attendant improvements in profits and employment among other things; and that the Fed, to guard against the longer-term risks of a financial bubble and generalized inflationary pressure, will need to think about a gradual shift toward a less accommodative monetary stance.  But the false signals of the past and the persistence of all the forces that have held back borrowing, lending, and growth signal that neither investors nor policymakers should take these preliminary signs as reason to change strategy yet, at least not radically.  Ignoring them would be dangerous—but it would be equally dangerous to extrapolate them.  Perhaps this is why Fed chairwoman Janet Yellen assiduously avoided reaching a conclusion during her recent testimony before Congress.

 

1M1 consists of currency in the hands of the public, travelers’ checks, demand deposits, and other deposits against which checks can be written. M2 includes M1, plus savings accounts, time deposits of under $100,000, and balances in retail money market mutual funds.
2All data from the Federal Reserve.
3Ibid.
4Ibid.
5Ibid.

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ABOUT THE AUTHOR

CRITICAL RELEASES IN THE WEEK AHEAD

Milton Ezrati examines the key economic and financial releases scheduled for the coming week. 

KEY MOVER:

Industrial Production for February*
Mon., March 17, at 9:15 a.m. ET
Previous: -0.3% • Prospect: +0.4%

Weather held back growth in January.  Weather could have the opposite effect in February, as utilities and fuel producers have had to gear up to higher demand.
*Source: Federal Reserve.

OTHERS TO WATCH:

Housing Starts for February*
Tue., March 18 at 8:30 a.m. ET
Previous: -5.4% • Prospect: -2.0%

Weather was a major factor in January, and no doubt was again in the February figures.
*Source: Department of Commerce.              

Leading Indicators for February*
Thu., March 20, at 10:00 a.m. ET
Previous: +0.3% • Prospect: +0.3%

The picture here should continue to show slow recovery, especially because of money growth.
*Source: The Conference Board.

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