Note the bottoming of the M1 money multiplier after its long secular decline. The multiplier is effectively the ratio of money created by the banking system (deposits) vs. money created by the central bank (reserves).
It collapsed and fell to below 1.0 after the financial crisis resulting in the current “liquidity trap.” For every dollar the Fed “prints” — i.e., reserves it creates to purchase treasury securities, for example — the money supply (M1) increases by less than the reserve creation or expansion of the monetary base. This is because depository institutions are hesitant to expand credit and have been shrinking their balance sheets while households have been deleveraging. In addition, the shadow banking system has collapsed and effectively shut down.
The decline in the M1 multiplier prior to the collapse was due to many factors, including the rise of the shadow banking system (securitizaton) , the expansion of activities of financial institutions, international capital flows, and financial engineering. This complicated the execution of monetary policy since Paul Volcker and led to policy errors, which partially contributed to the financial collapse and Great Recession, in our opinion.
Now with increased regulation and the lack of resurrection of the shadow banking system our sense is banking is going to get boring again, dominated by good old fashion lending. The money multipliers may well become an important indicator to think about and start to follow.
If credit markets are, in fact, healing and economic activity picking up, contemplating monetary theory and the consequences of the massive expansion of central bank balance sheets may become a higher priority of Mr. Market. We believe the money created by a healing financial system, coupled with the money created by the Fed with its planned trillion dollar asset purchase program, will provide underlying support to risk assets in 2013.
A risk the market begins to worry about the very things mentioned above and the potential for Fed panic and early exit from the super easy money is not zero. This was reflected in the market jitters after the release of the most recent FOMC minutes.
Monetary policy is increasingly dominated by fiscal policy (many can’t distinguish between the two – witness “the coin debates” — though Krugman does, however), is in uncharted waters, making it difficult to think clearly and consistent about its consequences. It’s early and we could be way off base but we think the time has come to begin focusing the issues of the money multiplier.
Keep it on your radar.
(click here if chart is not observable)