U.S. Still Seems More Apt for Deflation in Near Term

A nice quickie in the Wall Street Journal showing despite the massive monetary explosion created by the Federal Reserve, M2 (a measure of money) is flat lining.  Effectively what is happening is as quickly as money is being pushed into the system, a deflationary debt cycle is sapping it on the other end.  In layman's term, the Fed is trying to keep the bath tub full of water, by pouring new buckets of money inside of it, but all the holes at the bottom of the bathtub are just causing it to leak out. 

In a real world example of this deflationary debt destruction are all the strategic defaulters - the mortgages they took out 3, 4, 5 years ago for $X are now worth $Z.  The value of $Z is of course far less than $X so when they send in their jingle mail, the bank (theoretically) eats the losses between $X and $Z and into the ether goes that amount of money.  Of course the Fed has moved heaven and earth (and sacrificed the savers of the nation) so that banks can make up each mortgage loss by borrowing at nearly nothing and doing nothing more than buying US Treasuries [Apr 20, 2009: BB&T - A Better Way to Gauge How Banks Will Try to "Out Earn" Their Losses] - so incrementally week after week they are rebuilding their reserves on the backs of those who have "done the right thing".

So until "velocity" of money picks up - something we discussed in 2008 - all we have is a growing pot of money being pushed into the economy ... which seems to be concurrently being destroyed at an almost equal rate, and inflation still seems to be off in the distance somewhere.  Since there is little demand in the "real economy" (no velocity) [Feb 9, 2010: It's Not About Financing, It's About Lack of End Demand] what money is being created seems largely to be funneled into the Wall Street Economy (creating "prosperity") - which explains $80 oil even as the US (the largest user) grapples with inventory levels above the 5 year average, and most of Europe suffers from no growth.  From 2008:

I'll spare you the economic formulas but if you are interested, click here. Right now we have a problem of money flow - both the amount of "money" in the system, and the velocity of said money. In the simplest terms, just think of velocity as the amount of times money changes over. The higher the better. About 4-5 months ago both these areas (amount and velocity) were lacking. Capital was being destroyed in an over levered system; much of it unregulated in a "shadow banking system". For every 1 "actual dollar" in the system, 10-20-30x was "lent". Much of it was based on the housing bubble. So as the 1 actual dollar is destroyed, the capacity to lend 10-20-30x of that dollar is also destroyed - and your velocity of money crumbles. As we've outlined the past few months, our money supply is now going off the charts - the Federal Reserve has made it clear they will create money at any cost. They are going to do everything and anything in their power to liquidate the system, assuming I suppose that a currency crisis is a better outcome (or predicting no currency crisis will happen) than a financial crisis. It is very sad how we lurch from emergency to emergency in this country - but it is what it is.

The Federal Reserve balance sheet which used to consist of staid Treasury Bills was at $800Billionish last year, it is now approaching $2.3 Trillion and much of that is now the junk, I'm sorry - "the undervalued assets that once the market returns to normalcy will return to their rightful value- which will be MUCH higher" - that banks want to get rid of. It is now to the point the Federal Reserve will take it said "undervalued assets" off the books of hedge funds so our shadow banking system can re-emerge (the one that got us here in the first place) They are desperate and they will do anything.

So that's half the picture; the other is the even more tricky question of velocity. We are handing the banks (and other parts of the financial system) dollars by the wheelbarrow, but if they do not get circulated within the economy there are useless to everyone but banks. So we have one half the equation being force fed by the Fed/Treasury - the money supply will be ballooning - no matter the potential cost to the currency, and the other half of the equation is based on the belief that at some point so much money will be provided to said financial institutions that even the most risk averse will lend a portion. And we can begin anew. I won't even touch the long term questions this brings since we only deal with one crisis at a time.

Via WSJ

• No amount of huffing and puffing can inflate a leaky balloon.   The Federal Reserve's balance sheet has swelled to record levels amid the credit crisis, prompting concern that sharp U.S. inflation is soon to follow. But in spite of the Fed's bulging balance sheet, the nation's money supply is barely growing. That makes the prospect of near-term inflation less likely. 
• On Thursday afternoon, the Fed is due to release its latest weekly balance-sheet report, expected to show a small uptick from its prior $2.3 trillion level to a record high. To put that in perspective, the Fed's balance sheet was running around $800 billion before the credit crisis.  The Fed's holdings have soared over the past two years as policy makers opened a variety of emergency lending facilities, then embarked on a $1.25 trillion program to purchase mortgage-backed securities.
• These holdings could create the potential for inflation down the road as they are deployed in the economy. But right now, the system has sprung a leak.
• The nation's money stock, known as "M2," includes physical currency, bank deposits and households' money-market holdings. The money stock's growth, which historically averages around 5% a year, has stalled over the past 18 months since the credit crisis intensified in late 2008.
• The money supply contracted outright during much of January and February compared with its level 13 weeks prior, a gauge economists use to help smooth out weekly volatility.   Paul Ashworth, senior U.S. economist at Capital Economics. "It's not a good sign of healthy economy."
• The problem is twofold: the credit that serves as the lifeblood of the U.S. economy and helps create money is still in short supply, and demand for it is still weak. That raises the risk of deflation in the near term, not inflation.

Thankfully we are nothing like Japan.  Ahem.

Now for the good news for those of us in the speculator class....

• The silver lining is these conditions also give the Fed more leeway to keep interest rates low for longer without stoking inflation

Boo Yah!

As I said in 2009, there is no way the Fed raises interest rates in 2010.  The system is too frail despite all the green shoots.  [Jun 3, 2009: A Country that Cannot Function Without Easy Money] They know it, despite their happy talk.  I am sure Bernanke stares at that money supply chart and wonders how many more quarters of helicopter drops of fiat money it's going to take.