Q&A With Lacy Hunt

M1, FTHO, Currency 2021-01

Mish: Lacy, what what do you make of the Surge in M1 Money Supply?

Lacy

I focus entirely on M2 and have not looked at M1 for years.

Federal Reserve Credit and the monetary base increased by 64% and 37%, respectively, on a yearly average basis in 2020. Due to weak loan demand and frail capital position of the depository institutions, M2 increased 19.4%, on a yearly average basis.

Reserve requirements have been eliminated. Hence, the only regulatory restraint on the depository institutions is the liquidity coverage ratio, but this only applies to the large banks or those with heavy foreign exposure. Hence, for 2020, there was no effective regulatory constraint.

The depository institutions were simply not in position to utilize their deposits at the Fed to acquire additional assets even though the Fed has amended the Liquidity Coverage Ratio (LCR) to include Treasury holdings. The LCR will not be a factor in 2021 unless dramatic changes occur that I do not expect.

Thus, as long as the Fed purchases $120 of Treasury and agency paper, there will continue to be a first round increase in M2, but no second round increase. The increase in M2 will remain inactive, resulting in the excess liquidity trapped in the financial markets.

Emphasis was Mine.

Mish: Did you have any use for M3 that the Fed stopped publishing? 

Lacy: The value of M2 versus M3 has been an empirical question for me.  Both are explained by complex functions but the one for M2 is far more stable. This empirical finding has made M2 the preferred monetary aggregate. I have revisited this issue several times and the empirical results have continued to favor M2

Mish: Thanks Lacy 

End Discussion

That is a synopsis of several emails. I changed no words but did add emphasis. 

My question on M3 was in response to these Tweets. 

Reconstruction of M3

Despite the Fed halting publication of M3 it is easy enough to partially reconstruct as I did above.

Wikipedia Money Supply Discussion notes M3 consists of  M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.

The Large Time deposits lag by a month so in my chart I used the November number for December as well.

Except for eurodollars, the rest is easy enough to add together. 

Investopedia notes "Eurodollars are U.S. dollar-denominated deposits at foreign banks or at the overseas branches of American banks. Because they are held outside the United States, eurodollars are not subject to regulation by the Federal Reserve Board, including reserve requirements."

Thus, eurodollars have nothing to do with either euros or dollars. The term was invented before the euro came into existence. 

It's even more confusing because eurodollar futures are not a measure of the supply of eurodollars but rather the implied interest rate on eurodollars. 

I do not know how to estimate the actual supply of eurodollars, so I don't. 

Investopedia needs to update its discussion. The Fed eliminated reserve requirements. 

Investopedia M3 Errors

The Investopedia Discussion of M3 contains a number of errors. 

  1. Because of its shortcomings, M3 has since been eclipsed by money zero maturity (MZM) as a preferred measure of the money supply. 
  2. Since 2006, M3 is no longer tracked by the U.S. central bank, the Federal Reserve. The Fed did not use M3 in its monetary policy decisions even before 2006. However, the Federal Reserve Bank of St. Louis and some other sources still publish M3 figures for economic data purposes. As of December 10, 2020, M3 for the United States was $18.81 trillion.

I dispute statement 1 as a nonsense opinion. M2 is the widely used measure of money supply. 

Point two is clearly wrong. The St. Louis Fed posts M3, but if you look at the chart you will see it is M2 or nearly the same as M2. 

Historical M3 was way higher than $18.81 trillion in December as my chart shows. The St. Louis Fed chart of M3 is garbage.

St Louis Fed Blog M1 Errors

In researching this post I came across this question on the FRED Blog: What’s behind the recent surge in the M1 money supply? dated January 11, 2021.

Curiously, the writers for the St. Louis Fed do not yet know the Fed ended reserves.

"The Federal Reserve requires banks to hold reserves against checkable deposits," says the author, incorrectly.

What's Behind the Surge in M1 Money Supply?

Please reconsider my post What's Behind the Surge in M1 Money Supply?

Official Announcement

With little fanfare or media coverage, the Fed made this Announcement on Reserves.

"As announced on March 15, 2020, the Board reduced reserve requirement ratios to zero percent effective March 26, 2020. This action eliminated reserve requirements for all depository institutions." 

The St. Louis Fed not only missed a key point on reserves, the rest of the article is also highly questionable.

My conclusion:

"The Fed's balance sheet tactics are the key driver of M1, not people moving money into or out of checking accounts, not Biden, not the rich jumping ship, not real estate taxes nor any of the other claims tossed around."

After I wrote that position on January 7, 2021, I discovered this New York Fed Liberty Street article discussion.

Please consider What’s Driving Up Money Growth? by the Federal Reserve Bank of New York. 

M1 growth is highly positively correlated with the growth in reserves generated by Fed asset purchases. The reason for this is simple: Reserves held with the central bank are assets for banks. As the Fed expands reserves, banks must either sell other assets (keeping the overall level of assets unchanged), issue more liabilities or equity (expanding the level of assets), or some combination of the two. 

The Liberty Street article is from 2012. It still holds true. 

Be Careful of What You Read

This stuff is complicated enough already. Errors in widely read places, especially the St. Louis Fed Blog don't help. Be careful about what you read. 

Lacy's comments on M2 and excess liquidity remaining trapped ring true. He finished "You are a good friend. I prepared this explanation for you."

Thanks Lacy!

What About the Euro?

Inquiring minds may also be interested in A Reader Asks: Why is the Euro So Strong?

Those are my thoughts, not Lacy's.

Mish