The fact this is speculative in no way diminishes its importance but we want you to know: at this point it is just informed opinion albeit well-informed opinion.
From Global Macro Monitor, July 25:
This Rhyme Is Different: Base Money > M1
“History doesn’t repeat itself but it often rhymes.” – Mark Twain (maybe)
We have been speaking a lot about how the liquidity in the market today is different than in the past. The chart below reflects this better than anything we have seen.
The monetary base in the U.S. has exceeded M1, the most narrow definiton of money, since the financial crisis. The monetary base consists of money in circulation and reserves held at the Fed (see definition below).
The M1 money multiplier is still less than one, which reflects that for every dollar created by the Fed – an increase in the monetary base – results in a less than one dollar increase in the money supply (M1). Credit and deposit creation of commercial banks is thus still impaired, though improving and its repairment may be one reason why the Fed is a bit nervous and in tightening mode.
Watch This Space
A rapid turnaround and improvement in the money multiplier, which may be also be reflected in improving bank net interest margins and growing balance sheets, could act as an early indicator of potential inflationary pressures and a flag that the massive amount of high powered money in the financial system is being converted to credit based money.
The Fed is therefore walking a tightrope of an unstable equilibrium with inflation on one side and deflation on the other, especially if your main policy tool is to pay interest on a large portion of that high powered money. This, as the markets become increasingly convinced the global economy is now in a “Goldilocks” scenario, justifying extreme asset valuations and the record low volatility.
Note, the secular decline in the money multiplier, which reflects many factors, including the almost irrelevance of M1, foreign capital flows, financial innovation, technology and the rise of non-bank banks. For example, private direct lending is all the rage now with hedge funds and other non-bank banks.
Different Kind of Liquidity
The above illustrates why we are in a period of mainly central bank based liquidity rather than credit based liquidity — which can evaporate almost over night with, say, a financial or economic shock — as it did in 2008.
Upshot? It’s all up to the central banks, mainly the Fed and ECB, and when markets perceive it matters that they are removing money/liquidity from the system. And there is a lot of it out there, folks. Flooding the reservoirs with nowhere to go but to overflow into the asset and financial markets.
The stock of reserves in the financial system are what matter now (the Fed’s position), but flows will dominate when the market perceives they are approaching drought level conditions....MUCH MORE