When the Money Supply is Really Money Demand
Market monetarist Santa has a long naughty list
One of the things that dropped out of this week’s national accounts release was a still elevated household saving ratio of nearly 19% compared to 22.1% in the second quarter, which was a record high. I say dropped out, because the HSR is an unreliable and revision prone residual of household income and consumption, both of which are measured imperfectly and mainly for the convenience of the statistician. Given reduced consumption possibilities and increased uncertainty, an increase in the HSR is no surprise, but it has some interesting implications for monetary policy.
Saving can take many forms, including a reduction in household liabilities. There have been record rates of repayment of credit card debt, personal loans and mortgages since March. Credit card balances are at their lowest in 15 years, and mortgage offset balances are up around 10%. There has also been some substitution between saving vehicles thanks to the early release of super scheme, which has also been used to reduce liabilities.
Saving can also take the form of cash balances, reflecting the store of value function of money. Shane Wright picked-up on the $119 billion increase in bank deposits this year. The ratio of broad money to nominal GDP has increased from 107% pre-pandemic to a peak of 124% in the second quarter, moderating only marginally in the third, as shown below (note the data are de-seasonalised and NGDP is annualised):
This reflects very strong growth in monetary aggregates since March. I say ‘aggregates’ not to be fancy, but because referring to ‘the money supply’ is misleading. Growth in the stock of money is a function of both supply and demand, but what we have here is clearly a massive money demand shock, representing demand for the liquidity services provided by holding cash balances.
Another source of confusion is the secular decline in the use of cash as a medium of exchange. An increase in the demand to hold money is perfectly consistent with a decline in the use of cash for spending purposes because money demand is the opposite of spending, although could reflect cash-in-advance constraints. As the chart above shows, money demand has been increasing in secular fashion due to the growth in financial intermediation, which is a stylised fact of rising living standards, even as the use of cash for payments has declined.
One reason many commentators are confused about the efficacy of monetary policy is they assume strong growth in ‘the money supply’ must be inflationary, but a money demand shock is disinflationary, all else equal. Money demand is, of course, the inverse of velocity, or the rate at which we spend it. To illustrate, here’s Phil doing his bit for the velocity of money:
As our quantity theory identities imply, the money stock needs to be adjusted to offset a decline in velocity to keep nominal GDP stable, much less growing. A key contention of monetarism is that the price level in the long-run reflects the supply and demand of real money balances. When faced with a money demand shock, the central bank needs to work harder, not less. A big increase in ‘the money supply’ can be consistent with a central bank that is still not doing enough. $100 billion in QE looks somewhat less impressive set against such a massive money demand shock. Strictly speaking, we need a structural model to properly identify the demand shock. Fortunately, we have a convenient short-cut in terms of expectations for inflation and nominal GDP, which tell us whether monetary policy has been sufficiently accommodative. While money demand can be expected to moderate as the pandemic recedes, the pandemic shock will likely have a persistent effect on the demand for the liquidity services it provides.
The national accounts release showing an expansion for Q3 brought out the usual headlines about the recession being over. I previously discussed a better way of thinking about business cycle dating based on the classical Burns and Mitchell approach, which ties in very nicely with nominal GDP level targeting. For the record, real GDP is still 4.3% below its level in Q4 2019, much less a no-pandemic counterfactual in which the economy expanded in the first and second quarters, although it is worth noting the first quarter may well have recorded negative growth even in the absence of the pandemic.
Governor Lowe appeared before the House Economics Committee this week, where we learned Australian policymakers had been ‘very courageous’ in Phil’s generous self-assessment. So courageous in fact that the RBA Governor spent much of this year asking federal and state governments to do more with fiscal policy, so someone must have been lacking in courage. The opening statement to the committee said the Board is still ‘paying close attention to asset prices and trends in household debt.’ Keep the smelling salts handy, lest Phil and the Board once again get the vapours.
Governor Lowe made much of the fact that no country had taken interest rates negative (or more negative) during the pandemic, but this somewhat ignores both the BoE and RBNZ giving serious consideration to the option and both could still go there. Unlike the RBA, the RBNZ took the QE route early instead. The issue is not so much the choice of operating instrument, but the willingness to use those instruments, in which the RBA lagged its G10 peers.
We also learned that Tim Wilson sent Governor Lowe a Christmas card last year saying ‘no QE,’ which must establish Tim as some kind of massive contrarian indicator. Phil gave Tim his Christmas wish for far too long. Market monetarist Santa knows who has been naughty and who has been nice this year and sad to say this year’s naughty list is a long one.
Barry Eichengreen takes on Stephen Roach over the future of the US dollar in his presentation to the Marshall Society. But you already knew all that.