The following is excerpted from a commentary originally posted at www.speculative-investor.com on 17th March 2013.
The Fed continues to pump aggressively
During the six months since last September’s introduction of “QE3”, the Fed has grown its balance sheet by $341B by monetising (buying with money created out of nothing) mortgage-backed securities and Treasury securities. Moreover, $201B of this $341B increase has occurred over the past two months.
The recent acceleration in the Fed’s money creation hasn’t yet had a noticeable effect on the year-over-year (YOY) rate of growth in US True Money Supply (TMS). As illustrated below, at the end of February-2013 the YOY TMS growth rate was at the bottom of its 4-year range. The bottom of the 4-year range is still high by historical standards (almost 10%), but our calculation of the current monetary inflation rate is lower than expected considering what the Fed has done over the past few months.
We can’t be certain, but the lack of response in US TMS to the Fed’s recent aggressive money-pumping probably stems from the fact that the US TMS calculation is, by definition, the amount of US dollars within the US economy. It isn’t the global supply of US dollars, which means that in addition to monetary inflation and deflation in the US it will be affected by the flow of dollars into and out of the US. For example (and as noted in TSI commentaries at the time), US TMS was given a significant artificial boost during the second half of 2011 and the first half of 2012 by eurodollars (dollars deposited in bank accounts outside the US) fleeing Europe’s beleaguered banks for the perceived relative safety of the US banking system. With a general belief taking hold over the past six months that Europe’s debt crisis is over it’s likely that at least some of the money that fled Europe for the relative safety of the US has shifted back to Europe, creating a partial offset in our TMS calculation to the Fed’s recent money-pumping.
By the way, bank depositors in Cyprus, a tiny euro-zone country with a disproportionately large banking industry, are being asked to take a ‘hair-cut’ of up to 10% on their deposited funds as part of a bail-out just cobbled together by the euro-zone’s political and monetary leadership. This news could lead to another reversal in the net flow of dollars between Europe and the US if it creates fear that depositors in one of the larger euro-zone countries will lose some of their money.
While the flow of money to/from the US makes it more difficult for us to monitor what’s happening on the monetary inflation front, it doesn’t alter the actual situation. International money flows made the calculated rate materially higher than the actual rate from mid-2011 through to mid-2012 and are probably now making the calculated rate materially lower than the actual rate, but the actual rate is only affected by the money-creation/destruction activities of the Fed and US-based commercial banks.
The money pumping temporarily creates the illusion of a real recovery
Creating money out of nothing and pumping it into the economy can’t possibly help the overall economy. Some individuals will be helped at the expense of others, but the net effect over the long term will be a weaker overall economy. This is because the monetary inflation distorts the price signals upon which producers and investors rely. The only question relates to exactly how prices will be distorted. Which prices will rise the most and when will these price rises occur?
The answer to the above question is never known in advance of the money-pumping, even by those doing the pumping. However, educated guesses can be made. When the economy has been greatly weakened due to the effects of earlier monetary-inflation-caused price distortions (mal-investments), gold will almost certainly be a major long-term ‘beneficiary’ of the money-pumping. That’s unless gold has already become so expensive that it has fully discounted the future economic problems. In such circumstances gold will also often be a major short-term beneficiary, although that certainly hasn’t been the case over the past six months. Over the past six months the stock market has been the biggest beneficiary of the monetary inflation. This has surprised us more than it really should have.
That the monetary inflation has boosted nominal equity prices isn’t a surprise. Due to the way that “QE” pushes new money into the economy, stock markets will often be among the early beneficiaries. We are referring to the fact that the early receivers of the new money created by “QE” programs of the type implemented by the Fed will include investors/speculators who are likely to direct some of the new money towards equity purchases. The surprise is that for the moment the monetary inflation has given equity prices a substantial boost in REAL terms (in purchasing power terms and relative to gold). This is indicated by the following daily chart of the S&P500/gold ratio and the S&P500/gold ratio’s 390-day (roughly 18-month) rate-of-change (ROC). There is no evidence in this chart that the S&P500 Index has ended its secular bear market relative to gold, but notice that S&P500/gold’s 390-day ROC recently hit its highest level since the major stock market peak and gold trough of 1999-2000.
The market action of the past several months has brought about an unusually-wide divergence between economic performance and stock market performance. Clearly, the financial markets are discounting a real recovery in response to money-pumping. They will be proven wrong, but not necessarily right away.
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