Larry Kudlow offers an interesting analysis on the bloating of M2 and its effect on the stock markets and inflation/deflation. But first, what is M2?
From Wiki, it is accurate:
M1: Bank reserves are not included in M1.
M2: represents money and “close substitutes” for money. M2 is a broader classification of money than M1. Economists use M2 when looking to quantify the amount of money in circulation and trying to explain different economic monetary conditions. M2 is a key economic indicator used to forecast inflation.
M3: Since 2006, M3 is no longer tracked by the US central bank. However, there are still estimates produced by various private institutions. (M2 +large deposits and other large, long-term deposits)
So, M2 is money and close substitutes for money like savings deposits and timed deposits.
M2 is used to determine inflation when coupled with the ‘velocity of money’, how fast that one single dollar in your wallet with that unique serial number changes hands for goods and services over time. (Velocity times M2) gives us a good indication of coming inflation or deflation. If there is no or low velocity, there is no or low economic activity, so even with a high M2, there might not be inflation, in fact, there is an argument for coming deflation at that point.
Basically, 1 Gajillion dollars sitting in a bank not moving wont cause inflation, its only when each of these dollars gets used then there is inflation. the faster each individual dollar changes hand, the higher the inflation. So we have tons of money flying into the banks and just sitting there.
The Deflationary M2 Explosion
Fears over the safety and solvency of European government debt and banks are haunting the stock market.
Amidst the financial flight-wave to safety, with stocks plunging, gold soaring, and Treasury bond rates collapsing — and all the European banking fears which go with that — there’s an important sub-theme developing: An almost-forgotten monetary indicator, M2, which is mostly cash, demand-deposit checking accounts, savings deposits, and retail money-market funds, has been soaring.
According to the St. Louis Fed, M2 is up 24.2 percent at an annual rate over the past two months. Almost out of the blue, that comes to a near $500 billion increase. In rough terms, the M2 explosion breaks down to $165 billion in demand deposits and $335 billion in savings deposits.
What’s going on here? There’s a flight to government-guaranteed accounts. Some people believe Europeans are withdrawing from their own banking system and parking their money in the U.S. banking system, guaranteed by Uncle Sam. Kelly Evans reports in her Wall Street Journal column of a $30 billion outflow from equity mutual funds that has probably gone into cash.
This is a very disconcerting development. Normally, big M2 growth would signal a faster economy, and maybe even higher inflation. But as economist Michael Darda points out, the velocity, or turnover, of money seems to be plunging.
“The recent pickup in broad money in the U.S. looks like a dash for risk-free cash assets,” writes Darda. He also notes that widening corporate-credit risk spreads and shrinking government-bond rates signal a recession risk, not a coming boom.
So contrary to monetarist theory, the M2 explosion seems more closely related to a deflation/recession risk. Economist-blogger Scott Grannis writes, “The recent growth of M2 surpasses even the explosive safe-haven demand for money that accompanied 9/11 and the financial crisis of late 2008. Something big is going on, and it can only be the financial panic that is sweeping Europe as money flees a banking system that is loaded to the gills with PIIGS debt.”
Grannis concludes, “In short, it looks like there is a run on the European banks and the U.S. banking system is the safe-haven of choice.”
On the other hand, all may not be lost — at least from the standpoint of the American economy.
Economist Conrad DeQuadros, who acknowledges the precautionary demand for high cash balances in the current financial uncertainty, believes that the economic data do not yet signal recession. DeQuadros points out that jobless claims, hours worked, retail sales, and industrial production are all picking up. He also notes that profits are still rising, even though their growth is slowing. And C&I business loans have grown at an 8 percent annual rate over the past three months.
I would just add to all this: The biggest problem for the plunging stock market is coming out of Europe. Fears over the safety and solvency of European government debt and banks are haunting the stock market. I still don’t believe it’s 2008. But yes, like everyone else, I’m worried.
That said, we are awash with liquidity everywhere. U.S. banks and companies have more cash than they know what to do with. The problem is they are immobilized by fiscal policy run amok. We desperately need a regulatory rollback and flat-tax reform to boost asset prices and to get banks to loan, companies to invest, and America back to work.