Friday, July 31, 2009

The Big Question About Money Supply and the Stock Market

Nick emails and asks this very important question:

You keep on writing that because Bernanke has slowed the growth of the money supply, there will be a market decline. But what about the previous money that he has printed? Are you positive that ALL of that money has made its way through the system. Because if it hasn't, he can stop the growth of the money supply for a while and then resume without any trouble.
This is absolutely true. There is no method to know exactly how much of previously printed money is still working its way through the system---though knowing how to read the market helps a bit

This is why I usually wait some time to warn about a change in Fed policy. The current slowdown started in March, so we are now at month five. One would, thus, think any money Bernanke printed in January, February and earlier has pretty much worked its way through the system by now.

There is, however, another factor that may prop up the stock market for a bit longer. The recession caused a severe demand to hold cash, as we continue to get reports of a turning in the economy (because of Bernanke's earlier easing) the desire to hold cash has likely declined, which means investors are likely to be willing to spend more money to buy stocks, now, than say late last year.

The firepower won't be there to take it much, much higher if the Fed isn't printing, but the decline in the demand to hold cash can short-term be a countervailing factor that can push against an early decline.

The stock market and the economy are, as any good Hayekian would agree, very complex phenomena. To get the major trends correct is a pretty impressive task all by itself, to attempt to catch every wiggle is impossible. I think once read that someone figured out that if you correctly caught every uptick and down tick in the Treasury market over a year, and started with a thousand dollars trading the Treasury futures market, you would own the entire world three times over by the end of the year. Which is another way of saying that can't be done.

The economy is very complex there are no magic formulas or magic equations. At best, we can get general trends, which obviously, in and of themselves, can be very helpful, but they are not the complete charted course that informs of every wave and gust of wind.


  1. I think it was Friedman who observed that it takes about 18 - 24 months for changes in the money supply to fully work themselves through the system (somewhere in "Monetary Policy", which is actually very good).

  2. Friedman was discussing the impact of money supply growth on price inflation and cooked the number up when price inflation didn't kick in after the money growth of the 1980's.

    Bottom line His methodological aggregation and failure to understand Austrian methodological individualism caused problems for him from time to time.

  3. Robert, I was listening to Jim Puplava on Financial Senses this morning, and he like you noted that the Fed was limiting the money supply growth and the market began pulling back in June. Unlike you, he then noted that the Fed "increased their balance sheet by $200B" and then we got the July pop. I apologize, but I have to admit to a very thin understanding of money supply, and investigating this difference on my own would probably not result in much. Can you reconcile what Jim is talking about? Is this in line with your observations? Thanks very much for your continued analysis, not sure what I would do without it.

  4. @Steve

    He is talking about the Federal Reserve buying assets, but if they don't convert to an increase in money supply that means the assets were somehow neutralized.

    I haven't looked at how they were neutralized because it really is a waste of time to look at the monetary base (where these assets show up). If it doesn't get into the money supply it isn't impacting the economy.