The Independent Market Observer

The Growing Money Supply—Not a Risk

Posted by Brad McMillan, CFA®, CFP®

Find me on:

This entry was posted on Mar 23, 2016 4:54:22 PM

and tagged Economics Lessons

Leave a comment


money supplyYesterday, we concluded that the recent decline in money velocity is due to the money supply increasing faster than economic growth, rather than a collapse in growth itself. So, at worst, slower money velocity is a symptom of potential trouble rather than a cause.

Today, let’s consider another side of the issue: is the fact that growth in the money supply exceeds that of the economy itself either a symptom or cause of future economic trouble?

Economic growth and the money supply: what's the relationship?

Looking back 20 years. The following chart shows the connection between growth and changes in M2 over the past 20 years.

money_supply_1.jpg

As you can see, there has been a significant negative correlation between money supply growth and economic growth—that is, the faster the money supply grew, the worse the economy did, which is exactly the worry many have now. But before we conclude that fast money growth caused poor economic performance, we have to consider whether the bad economic performance caused the spike in money growth, rather than the other way around.

From a timing perspective, this looks quite plausible, as you can see above. From a policy perspective, with both the Greenspan and Bernanke Feds, it seems not only plausible but very likely. From an economic point of view, with two of the largest crises in history in the past 20 years giving rise to large monetary policy responses, it also seems likely. If so, the rise in money supply growth was not a cause of poor economic performance but a consequence.

Looking back 40 years. If that’s the case, the normalizing growth rate is actually a positive sign for the future. In order to test this idea, let’s consider the relationship between money supply and growth in another time period—say, the previous 20 years, as shown in the following chart.

money_supply_2.jpg

Here, you can see that the relationship between money supply growth and economic growth was positive, not negative, suggesting that the experience of recent years isn’t necessarily indicative of the future. The positive relationship was not large, of course, but this time period indicates that money supply growth hasn’t necessarily been bad for the economy.

Looking back 60 years. On the other hand, the 40-year time period also has its issues—notably, the inflation in the late 1970s and the Volcker high-interest-rate regime in the 1980s. If we go back another 20 years, we see that the relationship between money growth and economic growth is almost exactly the opposite of the past 20 years, as shown in the following chart.

money_supply_3.jpg

The change in the relationship between money supply growth and economic growth therefore seems reasonably related to monetary policy, which in turn depends to a large extent on economic events such as inflationary trends.

What happens when we compare money supply growth with consumer inflation trends? Once again, we see the same thing: a negative relationship, a positive relationship, and no relationship.  With no consistency, there seems to be no direct causal link.

What does experience tell us?

Given the mixed historical data, let’s think things through from basics. From a fundamental perspective, we should see the money supply grow along with the economy, as a larger economy needs more money to function. Last century, this is largely what happened, as the positive correlations between money supply and the economy show.

The reversal of that relationship this century is clearly inconsistent with fundamental expectations, as well as the actual experience of times when monetary policy was less active. The current relationship is therefore an aberration, caused by unusual monetary policies, which in turn were caused by—and not the cause of—recent economic crises.

This is good news. Going forward, we can expect that, as monetary policy normalizes, we will probably return to that positive relationship, where a growing economy needs more money and drives expansion of the money supply—which is exactly what we are seeing. The news isn’t all good, though, as the current growth rate of the money supply is actually slower than that of previous periods—and may well augur slower growth rates. Again, this would be consistent with both expectations and actual experience.

Although slower growth is not the conclusion we might hope for, it’s certainly better than a looming crisis. Based on our analysis, there is no real evidence that the current growth in the money supply could lead to one. Given the alternatives, I'll take continued growth, slow though it may be.

 

  Subscribe to the Independent Market Observer

Subscribe via Email

New call-to-action
Crash-Test Investing

Hot Topics



New Call-to-action

Conversations

Archives

see all

Subscribe


Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly in an index.

The MSCI EAFE (Europe, Australia, Far East) Index is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.

One basis point (bp) is equal to 1/100th of 1 percent, or 0.01 percent.

The VIX (CBOE Volatility Index) measures the market’s expectation of 30-day volatility across a wide range of S&P 500 options.

The forward price-to-earnings (P/E) ratio divides the current share price of the index by its estimated future earnings.

Third-party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided on these websites. Information on such sites, including third-party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®