[Chart Of Interest] Liquidity

The [Chart of Interest] post is a weekly blog spotlighting a highly informative chart and the significance on asset markets through the lens of the EPB Secular & Cyclical Framework.

[Chart Of Interest] Liquidity

There are many ways to measure liquidity or "money" in the financial system, and all have strengths and weaknesses.

One lesser known but important measure is called "other deposit liabilities," which essentially measures all deposits in the banking system but excludes the large time-deposits like "CDs" that are not readily spendable.

Adjusting this deposit measure by the CPI for a "real" metric allows us to compare liquidity growth across time and across periods of high and low inflation.

From 1950 until 2008, this liquidity measure, "real ODL," increased by roughly 2.0% per annum. Over this same period, the velocity of money increased at a 0.2% annualized rate, very stable.

After the financial crisis, real ODL increased at a 5.1% annualized pace. Despite money growth of 2.5x the historical average, inflation never leaked into consumer prices.

Why?

Since 2008, the velocity of money declined at a 3.6% annualized rate, completely neutralizing the 3.1% excess money growth.

The Federal Reserve is on track to reverse the excess liquidity by the middle of 2023 if they continue raising rates and reducing the size of its balance sheet.

Pausing interest rate hikes at ~3.5% is not problematic, particularly as the QT operations continue to withdraw liquidity.

If the Fed stays on track, liquidity will return to the pre-COVID 5.1% trend, which is still above the long-term rate.

However, the conditions that have caused the persistent decline in velocity, namely excessive debt, are still operative, so this is likely sufficient to bring inflation back into an acceptable range.

If the velocity of money stabilizes, then further liquidity drains will be necessary, but without an improvement in the productivity of debt, velocity will grind lower and offset the excess liquidity as it pertains to an increase in consumer prices.