No Golden Globes for the money supply 

Peter Warburton - 8 January 2019

In terms of their macroeconomic significance, think of the monetary aggregates as the discarded footage on the cutting room floor after the production of a blockbuster film. The erosion in the usefulness of the money supply as a useful macroeconomic indicator began in the 1980s but suffered a hammer blow when the US established a new monetary policy regime in the wake of the 1994 bond bear market. As the US Fed’s focus shifted from domestic to global, it assumed the mantle of the guardian of global financial stability. Over the past 25 years, the relationship of the global broad money aggregates to global inflation, expressed here by the CPI inflation rate, has been transformed. Money-inflation correlation patterns have reversed.

Imagine that you entered an old film studio just after the completion of a blockbuster production. Sundry lengths of discarded footage lay strewn across the floor. You stoop down and pick up a length of film and hold it to the light.  You can pick out the scenery and take a decent guess as to its location and you can even make out the faces of those cast in the star roles. Examining length after length of cellulose, you even begin to catch a sense of the storyline. You are excited by your discoveries and start to tell all your friends about your scoop on the yet-to-be-released film. The date of the release is announced, and you wangle a ticket to the preview. You watch expectantly as the plot unfolds, only to find that the narrative of the film takes a very different course to that which you had imagined.

Observe first the size of the correlation coefficients. In the case of M0 (figure 1), the contemporaneous coefficient has plunged since 2008 from the range 0.8 to 0.9 into negative territory (-0.2). The implication is that the monetary base has become redundant for the purposes of macroeconomic forecasting. The rolling 20-year inflation correlations for global M3 growth, shown in figure 2, has been profoundly negative since around 2000, but became superficially more supportive of a positive monetary influence over the past 5 years. However, the absolute level of the correlation coefficient is barely positive. 

While money supply measures still contain information that is relevant for financial markets – not least in the context of the recent global equity sell-off – their value as leading economic indicators has been rendered null and void by the reorientation of the global economic and financial system towards debt and leverage. The money numbers look interesting, but they express the consequences of prior credit decisions. For both the global monetary base and global M3, the strongest correlation is where inflation leads money by 1 year. Rather than predictive of nominal activity and inflation, they are recursive to it.   

A vast, global, edifice of private sector debt underpins the pricing of commodities, goods, services and assets. The health of the global credit system is of paramount importance to economic and financial development. This may help to explain why central banks no longer consider it their responsibility to rein in credit excesses, but rather to perpetuate credit cycles.

A tightening of global credit conditions, such that the inflation-adjusted pace of debt growth slackens, yield curves invert or credit spreads widen, is considered an undesirable turn of events, to be avoided whenever possible. The migration of risk from bank balance sheets to the corporate bond market and the reorientation of risky lending from banks to asset managers carries us ever closer to another fracture of the global credit system. Should this crisis erupt, it will unleash a deflationary shock to asset prices and consumer prices alike.

Figure 1

Data source: Thomson Reuters Datastream

Figure 2

Data source: Thomson Reuters Datastream

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