Money supply and rising interest rates

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by Alasdair Macleod, GoldMoney:

The establishment, including the state, central banks and most investors are thoroughly Keynesian, the latter category having profited greatly in recent decades from their slavish following of the common meme.

That is about to change. The world of continual Keynesian stimulus is coming to its inevitable end with prices rising beyond the authorities’ control. Being blinded by neo-Keynesian beliefs, no one is prepared for it.

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This article explains why interest rates are set to rise substantially in this new year. It draws on evidence from the inflation crisis of the 1970s, points out the similarities and the fact that currency debasement today is far greater and more global than fifty years ago. In the UK, half the current rate of monetary inflation for half the time — just for one year — led to gilt coupons of over 15%. And today we have Fed watchers who can only envisage a Fed funds rate climbing to 2% at most…

A key factor will be the discrediting of this Keynesian hopium, likely to be replaced by a belated conversion to the monetarism that propelled Milton Friedman into the public eye when the same thing happened in the mid-seventies. The realisation that inflation is always and everywhere a monetary phenomenon will come too late for policy makers to stop it.

The situation is closely examined for America, its debt, and its dollar. But the problems do not stop there: the risks to the global system of fiat currencies and credit from rising interest rates and the debt traps that will be sprung are acute everywhere.

Introduction

Clearly, the outlook is for higher dollar interest rates. The Fed is trying to persuade markets that it is a temporary phenomenon requiring only modest action and that while inflation, by which the authorities mean rising prices, is unexpectedly high, when things return to normal it will be back down to a little over two per cent. There’s no need to panic, and this view is widely supported by the entire investment industry.

Unfortunately, this narrative is based on wishful thinking rather than reality. The reality is that over the last two years the dollar has been dramatically debased as part of an ongoing process, as the chart in Figure 1 unmistakably shows.


Since February 2020, M2 has increased from $15,470 to $21,437 last November, that’s 38.6% in just twenty months, an average annualised inflation rate of 23.2% for nearly two years on the trot. And that follows unremitting expansion at an accelerated pace since the 2008 Lehman crisis, an inflationary increase of 175% since August 2008 to November 2021. If the CPI is the relevant measure, then its current indicated rate of price inflation at 6.8% is only the beginning of upward pressure on prices.

For now, markets are ignoring this reality, hoping the Fed is still in control and can be believed. But we can be sure that it will soon become apparent that the monetary authorities have a major problem on their hands which will no longer be satisfied by jaw-jaw alone. Interest rates will then be destined for significantly higher levels, not because there is demand for capital against a background of limited savings supply, but because anyone holding dollars will require compensation for retaining them. A similar error is to think that with economic growth slowing from its initial recovery and with concerns that the world may be entering a recession, demand and supply will return to a balance and prices will stop rising.

These errors aside, the 10-year US Treasury, which is currently yielding 1.7% cannot continue for long at these levels with CPI prices rising at 6.8% and more. And in the next few months, with higher producer prices, energy, and raw material costs in the pipeline the pressure for a substantial upwards rerating of bond yields (which is a catastrophic fall in prices) is only going to increase.

International investment flows

This article is less concerned with the implications for financial asset values than with how such a shock will affect the currency and confidence in monetary policy. The dollar is over-owned by foreign interests, which with cash deposits and investments now exceed $33 trillion, 145% of estimated current US GDP and not too far from the Bank of International Settlements’ estimate of US non-financial core debt.[i] Of this foreign ownership, nearly $27 trillion is in long-term securities, with private sector ownership of equities by foreign investors standing at $12.5 trillion within that figure.[ii]

It should be appreciated that nearly all foreign ownership of US equities is with profits in mind only: foreigners may be required by their regulators to hold domestic equities, but there is no such requirement covering foreign equities. Consequently, an increase in interest rates of a magnitude suggested by the dollar’s debasement can be expected to trigger an avalanche of foreign selling of all classes of financial assets. Whether they sell the dollar as well will depend partly on how high interest rates are permitted to rise, and partly on alternative currency, precious metal, and commodity options.

Countering foreign investment in USD financial assets, US residents’ investment in foreign currency assets is far less, with only $651.4bn of foreign currency deposits and short-term investments, one tenth of foreign entitlements to dollar bank deposits and ownership of Treasury and commercial bills. But ownership by US investors in long-term foreign securities stands at $15.7 trillion, less than half the foreign position in US securities, of which $12 trillion is in equities. A bear market in US stocks will therefore lead liquidation of foreign stocks as well, ensuring an equity bear market in the US will become truly global. But the net effect on the dollar is likely to be negative

Another aspect for foreign holders of dollar assets to consider is the ongoing supply of dollars and dollar credit. So far, the prospect of further dollar debasement relative to other currencies has not been reflected on the foreign exchanges because the other major currencies face similar outcomes. This may be changing. The euro and Japanese yen have weakened significantly recently with the ECB’s and Bank of Japan’s deposit rates trapped below the zero bound.

The inability of governments and monetary authorities to escape from currency debasement is what will ultimately matter, setting the scene for purchasing power, interest rates and systemic instability. For now, prospects for the money supply of the world’s reserve currency are central to these issues.

Does M2 truly represent the dollar’s money supply?

In February 2021 the Fed changed the components in M1 and M2 and began to report them monthly instead of weekly. Put simply, savings deposits at the banks were added to M1, which accounted for a large jump in the M1 total. Adjustments to prior figures were only backdated to May 2020 onwards, rendering it useless for comparisons with data prior to that date.

The composition of M2 was left unchanged.[iii]

There are two additional factors, which arguably should be included in M2. The first is IRA and Keogh accounts at the banks. Presumably, they are excluded on the basis that they are not readily available for consumer spending, and if they are withdrawn from one bank, they must be deposited in another. But this ignores the fact that they are part of the deposit money which banks deploy for their dealings in credit, and that the total of these deposits varies. They should therefore be included in any bank deposit-based definition of the money supply. The effect of including these balances is to increase M2 today by $974bn (November 2021).[iv]

The second factor is the treatment of repurchase agreements (repos and reverse repos or RRPs), which are tools for liquidity management both between commercial banks and between the banks and the Fed. We are not concerned with inter-bank repos, because they do not affect the overall amount of currency and credit in circulation. But when the Fed is one counterparty, the situation is different.

Readers may recall the liquidity crisis in September 2019, when the Fed stepped in and provided finance by providing repos to commercial banks. When the Fed acts in a repo transaction, it buys high quality assets (usually US Treasury bills, Treasury bonds or agency debt) with an agreement to sell them back on pre-agreed terms, which will give the Fed a profit, currently set at an annualised rate of 0.05%. The selling bank then has use of the cash proceeds over the duration of the repo, until the transaction is completed by the bank repurchasing the collateral from the Fed on the pre-agreed terms, thereby returning the cash. Because these transactions are short-term, usually providing overnight liquidity, there is little point in including them in money supply statistics.

A reverse repo is the other side of a repo transaction. If a commercial bank has too much liquidity on its balance sheet it can use a reverse repo to provide it to another bank in need of liquidity on profitable terms. But if the Fed is the counterparty to a bank or eligible institution in a reverse repo then liquidity is being taken out of general circulation reducing money supply on a short-term basis. Therefore, an increase in the Fed’s reverse repo book reduces the M2 money supply figure below what would otherwise be reported.

For the Fed, repos and reverse repos are overnight liquidity management tools to allow the Fed to keep its funds rate within the limits set by the Open Markets Committee. Repos are deployed to put a cap on interest rates and reverse repos a floor.

But commercial banks are unlikely to make use of the reverse repo facility. The only way a bank will be encouraged to enter a reverse repo transaction with the Fed is as a dealer in credit. The return on an RRP must exceed alternative uses of the liquidity available to a bank on the liability side of its balance sheet. Banks will not undertake a reverse repo with the Fed because the rate is fixed at 0.05%, which is less than the interest paid on bank reserves at 0.15%.

But on 31 December last week, the Fed’s total reverse repo operations stood at $1.905 trillion (it has since declined by $400bn because in the last few trading sessions the yield on 13-week T-bills has risen to 0.085%, giving a higher yield than that offered by the Fed’s reverse repo facility). Nonetheless, outstanding overnight reverse repos are still a very large item. If commercial banks are disinterested because they earn more on their reserves, then who are the Fed’s counterparties? The answer is money funds.

Money funds faced two problems. With interest rates fixed by the Fed at the zero bound, there is a heightened risk that they will “break the buck”, in other words they would no longer be able to guarantee to return their investors’ capital. The second problem is that commercial banks are no longer interested in acting as counterparties in wholesale money markets absorbing money funds’ liquidity. The issue is Basel 3’s net stable funding ratio rules introduced on 1 July. The NSFR is intended to ensure that banks have stable funding for their activities, and a bank exposed to large depositors, who might withdraw their deposits at little or no notice, for the purpose of the NSFR rules do not constitute a stable source of funding. Consequently, banks are no longer interested in taking in deposits from the money funds permitted to deposit money with them through wholesale money markets.[v]

Therefore, all money funds are driven towards the New York Fed’s Open Market Trading Desk to earn a paltry 0.05% on their funds when the yield on 13-week T-bills declines towards the zero bound. This facility was specifically opened to them in March 2020 when the Fed reduced its funds rate to 0—0.25%. Ahead of the NSFR’s introduction to US bank regulations last June, the Desk’s reverse repo facility stood at just a few billion from which it exploded to nearly $2 trillion last week, coincided with the NSFR’s introduction. And for money funds restricted to dealing in T-bills and the Fed’s reverse repos, the T-bill rates also dropped. The consequences for the Fed’s reverse repo facilities is illustrated in Figure 2.

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