Reading the monetary tea leaves; Y2K and currency loom large
Scott F. Grannis - Economist for Western Asset
November 1999
Reading the monetary tea leaves is a task that is not undertaken often or lightly. That's because the data on monetary aggregates accurately reflects the supply of money, but says little about the demand for money. And of course it is the nexus of the two that determines whether monetary policy is inflationary or not.
Despite these inherent difficulties, inflation worriers lately have taken to citing monetary statistics which they claim have turned inflationary. The charts here attempt to show that whether or not inflation is a problem (and it doesn't appear to be), the monetary statistics per se do NOT support the case for rising inflation.
To begin with, the only monetary aggregate which is growing at an unusually rapid pace is the monetary base, which in turn is composed of bank reserves and currency in circulation. As the following chart illustrates, it is the growth of currency (which comprises about 85% of the base) which has dominated the growth of the monetary base. Currency growth has been remarkably stable and robust over the past 20 years, as the next chart shows, averaging just over 8% per year. Though it seems excessive, this growth must be the result of worldwide demand for dollar currency, otherwise there would be almost $4,000 in currency in the U.S. for every working person. Besides, the Fed cannot push "too much" currency out into the world; who would unwillingly hold a non-interest-bearing asset unless it served a useful purpose? Since currency demand must equal currency supply, strong growth in currency (contrasted to just 4.2% annual growth in M2 in the Greenspan era- 4.6% growth currently) is not inflationary.
As this chart shows, sweep-adjusted bank reserves in the Greenspan era have grown only 3.2% per year. Reserve expansion has been dominated by the Fed's policy stance: growing when policy was easing, and steady or contracting during periods of tightening. What stands out is the explosive growth of reserves in the past few months even as the Fed has tightened policy. This can only reflect a surge in demand for liquidity which the Fed is accommodating in order to keep the funds rate at its targeted level, and Y2K is the only logical source of this sudden demand.
We know the Fed has declared itself willing to inject liquidity to meet Y2K demands, we know it has printed up to $100 billion in extra currency, and we hear of banks increasing their vault cash in preparation for Y2K demand. Thus, the surge in monetary base growth is highly likely a temporary phenomenon, to be unwound after year end. If it isn't, then there would be cause for concern.
This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission.
Scott F. Grannis - Economist for Western Asset
November 1999
Reading the monetary tea leaves is a task that is not undertaken often or lightly. That's because the data on monetary aggregates accurately reflects the supply of money, but says little about the demand for money. And of course it is the nexus of the two that determines whether monetary policy is inflationary or not.
Despite these inherent difficulties, inflation worriers lately have taken to citing monetary statistics which they claim have turned inflationary. The charts here attempt to show that whether or not inflation is a problem (and it doesn't appear to be), the monetary statistics per se do NOT support the case for rising inflation.
To begin with, the only monetary aggregate which is growing at an unusually rapid pace is the monetary base, which in turn is composed of bank reserves and currency in circulation. As the following chart illustrates, it is the growth of currency (which comprises about 85% of the base) which has dominated the growth of the monetary base. Currency growth has been remarkably stable and robust over the past 20 years, as the next chart shows, averaging just over 8% per year. Though it seems excessive, this growth must be the result of worldwide demand for dollar currency, otherwise there would be almost $4,000 in currency in the U.S. for every working person. Besides, the Fed cannot push "too much" currency out into the world; who would unwillingly hold a non-interest-bearing asset unless it served a useful purpose? Since currency demand must equal currency supply, strong growth in currency (contrasted to just 4.2% annual growth in M2 in the Greenspan era- 4.6% growth currently) is not inflationary.
We know the Fed has declared itself willing to inject liquidity to meet Y2K demands, we know it has printed up to $100 billion in extra currency, and we hear of banks increasing their vault cash in preparation for Y2K demand. Thus, the surge in monetary base growth is highly likely a temporary phenomenon, to be unwound after year end. If it isn't, then there would be cause for concern.
This publication reflects current opinions of Western Asset Management and is for educational purposes only. Information contained herein, including data supplied by others, is believed to be accurate, but cannot be guaranteed. Opinions represented are neither a recommendation nor an offer of securities and statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This material may not be reproduced in any form without written permission.