Annual growth of US broad money, on the M2+ definition* used here, rose further to 25.7% in May, the fastest since 1943 and more than 20 percentage points higher than a year earlier.
The economist consensus is that the monetary surge will not result in a rise in inflation because of an offsetting fall in velocity**. The required 20% plunge, however, would be unprecedented – about double, for example, the decline in 2008 at the height of the GFC.
The view here is that an inflation pick-up will be avoided only if the monetary surge is rapidly reversed. A return of growth to its prior level is insufficient – the level of the money stock needs to contract significantly.
Such a scenario should not be dismissed out of hand. Broad money contracted by 5.2% between May 2009 and June 2010 during the initial economic and market recovery after the GFC. That weakness, however, partly reflected commercial banks restructuring their balance sheets to meet official demands for an increase in capital ratios, while a larger decline would be required now because of the monetary overhang.
Two other scenarios should be considered. Annual broad money growth is almost certainly peaking. Suppose that it returns to its year-ago level of 5.1% in 12 months’ time. Allowing for a rough two-year lead from money to prices, this would suggest a temporary inflation rise to a peak in 2022 followed by a return to around the 2010s average.
An alternative scenario, favoured here, is that broad money growth will remain elevated by recent standards, meaning high single digits, at least, compared with a 10-year average (to 2019) of 3.9%. This would suggest a structural shift higher, or secular rise, in inflation.
What are the probabilities of the above three monetary scenarios? A starting point for an assessment is an analysis of the causes of the recent surge.
Unlike other central banks, the Fed does not provide a counterparts breakdown linking changes in broad money to other elements of the monetary system balance sheet. The table cobbles together available information.
Several points are notable. First, the Fed’s securities purchases made the largest contribution to the rise in money growth over the past 12 months but much of the impact was offset by an increase in the Treasury’s balance at the Fed. The latter has had the effect of deferring part of the monetary boost from QE until the Treasury disburses the funds.
Secondly, purchases of government securities by commercial banks and money market funds, surprisingly, made the second largest contribution. This buying can be viewed in two ways. Market weakness in Q1 caused investors to switch into cash. Institutional money funds, in particular, experienced large inflows and invested excess liquidity in Treasury bills.
An alternative explanation is that banks and money funds – along with the Fed – are the buyers of last resort of Treasuries and agencies. There has been record issuance of both – $3.29 trillion of marketable Treasury securities in the 12 months to May and $505 billion of agency securities in the 12 months to March. With the household sector and foreign investors selling Treasuries / agencies, banks and money funds have been required to increase holdings despite record Fed absorption.
Thirdly, banks’ commercial and industrial (C&I) lending rose significantly but broad money growth would be above 20% even without this boost. Much of the lending was associated with the Paycheck Protection Program (PPP), which stood at $510 billion at end-May compared with a 12-month increase in C&I loans of $703 billion.
The contribution to the rise in money growth of the other counterparts, derived as a residual, was similar to that of C&I lending. This may partly reflect banking system lending to foreign entities to relieve a shortage of US dollars, including Fed lending via central bank liquidity swaps, which stood at $448 billion at end-May.
The figures for May 2021 in the right-hand column of the table represent speculative projections based on the following considerations.
The Fed’s contribution to broad money growth is likely to be much smaller but still significant over the coming 12 months. The June policy statement committed the Fed to increase its holdings of Treasuries and agencies at least at the current pace, i.e. $80 billion and $40 billion per month respectively. The projection assumes that purchases continue at this rate through December, implying totals of $560 billion of Treasuries and $280 billion of agencies.
The Treasury’s balance at the Fed stood at $1.33 trillion in late May and has since climbed further to more than $1.6 trillion. The projection assumes a fall to $500 billion in May 2021, still well above "normal" (it averaged $300 billion in 2019). The current high balance partly reflects pre-funding of PPP loan forgiveness, the bulk of which is likely to occur during H2 2020.
The net monetary impact of PPP loan forgiveness, assumed here to cover most of the program, will be neutral because the Treasury pay-out will be offset by a fall in commercial banks’ C&I lending – banks will, in effect, swap loans for reserves at the Fed. With excess reserves already high, this is unlikely to result in additional lending.
System-wide bank lending to firms, however, could be boosted by the Fed’s Main Street Lending Program (MSLP) and its Primary and Secondary Corporate Credit Facilities (CCFs), involving purchases of corporate bonds. The MSLP and CCFs have size limits of $650 billion and $750 billion respectively and will run until end-September. MSLP take-up and Fed CCF buying are uncertain: the table assumes a combined $500 billion, balancing the suggested fall in C&I loans.
Another entry subject to significant uncertainty is commercial bank and money market fund transactions in Treasuries and agencies. Economic and market normalisation might be expected to reverse recent inflows to banks and money funds, resulting in them selling securities. Treasury issuance, however, will remain high, possibly requiring additional absorption. Based on the CBO forecast of federal deficits of $3.7 trillion and $2.1 trillion respectively in fiscal years 2020 and 2021, the earlier assumption of Fed Treasury purchases of $560 billion in the year to May 2021 implies central bank coverage of perhaps only one-quarter of Treasury funding needs.
The residual counterparts are assumed to undershoot their contribution in the year to May 2019 to compensate for an overshoot over the past 12 months.
The projections, in combination, suggest broad money growth of about 10% in the 12 months to May 2021, consistent with the medium-term inflationary scenario outlined earlier. The individual assumptions can certainly be questioned, although the intention was to be conservative. The main takeaway from this exercise, however, is the difficulty of generating a forecast of monetary contraction to reverse the recent surge and support consensus inflation complacency.
*M2+ = M2 + large time deposits at commercial banks + institutional money funds. M2+ is the broadest available monthly measure. The old M3 measure, discontinued in 2006, also included repos and Eurodollar deposits – the Fed no longer releases monthly data on these.
**Conventional velocity, i.e. the ratio of nominal GDP to money, rather than “true” velocity, as defined in the quantity theory of wealth.