Headline CPI came out this morning and surprised to the downside, 2.6% year-over-year versus 2.8% expected. Core CPI was also cooler than expected at 1.6% versus the 1.8% predicted by economists. Watchers of the monetary aggregates aren’t as surprised, but who watches M2 anymore? Every economic theory enjoys its time in the sun, but ideas fall in and out of popularity. Monetarism is no different. Money supply data used to be pored over upon its release by the Fed. If it was 4:30 on a Thursday, you could be sure to find professional and amateur Fed-watchers alike holding their collective breath in anticipation of the new data. Those days are long gone, as the Ms seemingly haven’t had the same predictive power (more on this and its deflationary portents next week). We believe that the tracking and analysis of money supply will enjoy its day in the sun again, and in the meantime we plan to keep watch.
We’ve taken to following a measure of money supply that adds together M2 and the only surviving component of M3: institutional money funds. As you can see below, it has been falling since June of 2009 and is now down year-over-year.
Money supply spent all of 2009 in a deceleration pattern, a period in which we had actual CPI deflation, a rare event. Since the peak in June of 2009, this measure of money supply has dropped $314 billion from a peak of nearly $11 trillion. It’s in the harsh light of a falling money supply that we view the recent announcements from Fannie Mae and Freddie Mac that they will be purchasing delinquent loans from pools of loans that they guarantee. These purchases will flow through to holders of agency MBS in the form of prepayments over a relatively brief period, to the tune of roughly $200 billion in cash. This isn’t only an event for holders of these securities, it’s likely that it could be a money supply event as well, showing up in the aggregates. It would be easy to look at $200 billion on a base of over $10 trillion as a drop in the bucket, but this would be a mistake. It would eliminate most of the decline from the peak in money supply, and more importantly, it could be misinterpreted as an inflationary threat. Any poor economist watching the aggregates and interpreting this spike as a precursor to surging inflation would be mistaken, and if this economist is in a position to make or influence policy, this could be bad news all around. It’s important to remember that inflation is not a step function; inflation is a rate of change. This means that a one-time blip in cash isn’t “inflation”, it’s a level change. And likely a temporary one.