Central bank nostalgia and an equilibrium | FT Alphaville

Central bank nostalgia and an equilibrium

This trip down the central bank money supply lane will seem almost nostalgic to some people, so we thought it’d be worth a revisit.

It is excess rather than gross money supply that generates upward pressure on asset prices or prices of goods and services in the economy.

That’s from JPMorgan’s excellent Flows & Liquidity team, in a note published on Friday.

The analysts draw our attention to the size of central bank balance sheets and how such snapshots give an obviously misleading picture of money supply growth. ‘Misleading’ as not all of an expansion will find its way into the real economy and hence monetary aggregates.

Since the pivotal moment when Lehman failed, G4 central bank balance sheets have increased by 125 per cent. Over the same period the money supply (M2) increased by only 33 per cent, say the team at JPMorgan.

Over the past year, G4 central bank balance sheets grew by 21 per cent and the G4 M2 money stock actually contracted by 1.8 per cent:

And here’s an example of this transmission stickiness in action in the US, from the FT on Monday:

The Federal Reserve’s attempt to push aid into the heart of the US economy is being blunted by banks struggling to process mortgage applications fast enough, keeping rates on home loans elevated, according to the largest lenders…

[QE3] was partly designed to ease further the cost of mortgages, but bankers say the impact will be limited by a dearth of loan officers with banks reluctant to cut mortgage rates without the staff to process any increase in business.

“In the very near term [QE3] has virtually no transfer mechanism whatsoever to the customer,” said one executive at a leading lender, who requested anonymity. “Originators are massively backlogged in terms of origination volumes.”

By this point you should be fairly wary of data gleaned from central bank balance sheets, without any context of what money supply has been doing. However, the JPMorgan team also want to point out that even the money supply data isn’t enough. Taking us back to Econ 101, they put forward the demand side of the equation too. Without that, there’s no way to assess the potential inflationary impact of monetary expansions:

It is often the case that the money stock is associated with the concept of money supply, but the truth is that we do not know whether the observable money stock reflects demand or supply. In fact, it likely reflects both if an equilibrium exists between demand and supply at all times. To facilitate the discussion below, we associate the observable money stock to “money supply” and focus on deriving a medium-term target for the money stock which we associate with “money demand”.

The JPMorgan analysts then have a crack at modelling supply and demand for the G4 of the US, eurozone, UK, and Japan. It’s a pretty rough model, what with all that aggregation, but the output is nonetheless interesting:

From the above chart, the supply and demand for money appear balanced — the gap closed in August for the first time since 2009 when a post-Lehman shortage was felt.

The current conditions are, in theory, the optimal environment for policy action to occur in as the impact of central bank stimulus is more likely to be felt. The broader money supply may actually expand.

If banks hired more people to process those mortgages, that is…

Related links:
Is QE3 justified? Comparing current conditions with 2010 – Sober Look
Can the Bank keep Posen, please? – FT Alphaville
Diagram du jour: How the ECB transmission mechanism is broken – FT Alphaville
About that broken ECB transmission mechanism… – FT Alphaville