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The Money Supply Mystery

Mar 03, 2021

Executive Summary

  • Broad money supply has surged to record levels in the United States, causing inflation fears and overstated claims citing the US Dollar demise.
  • A money-centric view of the economy ignores our economic system's foundation, which states that money has an equally important counterpart - velocity.
  • It has become fashionable to denounce velocity as a measure of our economic and monetary system, but that still does not change what the measure of velocity is telling us.
  • Today's inflationary impulse is not a result of large increases in the money supply but rather a pent-up demand manufacturing rebound stemming from a change in consumer spending patterns, colliding with lockdown-induced supply chain disruptions.
  • This article will help clarify the mystery of the surging money supply and its impact on GDP growth and inflation and get to the root cause of today's transitory, albeit violent, surge in inflation.

The Money Supply Mystery

(To expand images, you can "right-click" and select "open image in new tab.")

Over the past year, to combat the economic fallout from the COVID-recession, various monetary and fiscal policy measures caused a surge in the broad money supply "M2". Large fiscal stimulus, including direct household payments, and large-scale Quantitative Easing "QE" both contributed to record M2 growth. 

Conceptually, it is logical to assume that increases in broad money should lead to inflation. After all, "more money chasing the same number of goods" means inflation, right? 

Unfortunately, our monetary system is more complex than simple axioms from economics 101. 

In this note, we'll discuss the surging rate of money supply growth and why the claims about lasting inflation or the US Dollar demise are overstated.

It has become popular to demonize other monetary and economic variables such as the velocity of money and the money multiplier, and in this note, we'll cover what those measures are telling us and why they are still highly relevant. 

Lastly, in the final section, we'll discuss today's transitory yet powerful inflationary impulse and explain why it is not related to surging money supply nor fiscal stimulus but rather a radical change in consumer behavior. 

The current inflationary impulse is strong; in fact, it is shaping up to be one of the stronger inflationary surges in the last several decades. Still, however, a large one-time rise does not change the long-standing variables that define our economic and monetary system, nor does it change the secular trends of productivity and demographics that are primarily responsible for the low rate of economic growth and inflation we have experienced over the past 30 years. 

Money Supply, Velocity, Money Multiplier & GDP

To fully understand the trends in the economy, we have to start with a brief overview of the equations that define our economic and monetary system. 

First, the equation of exchange states that nominal GDP is equal to money supply times velocity. Written as an equation: 

GDP = M2 * V

Interestingly, from this equation, we have three variables, GDP, money supply, and velocity. Nominal GDP is the best economic data series we have in this country in terms of accuracy and depth. Nominal GDP is revised multiple times, on an annual basis and on a 5-year "benchmark" basis. GDP in per capita terms has the closest correlation with the average standard of living over time. 

GDP is also a nominal series which eliminates the price mismeasurement debate that often surfaces when discussing "real" economic data series. 

It is reasonable to move forward with an understanding that GDP is one of the best, if not the best economic data series with a century of data. 

Velocity is calculated as a remainder meaning that once we have nominal GDP and we have the quarter-average of money supply, then GDP/M2 = V. 

If GDP is a great measure, and analysts are using M2 as the main argument for their inflationary thesis, then how can two good measures produce a bad measure? 

Velocity simply measures how much GDP is generated per dollar of broad money. If the money supply increases dramatically, but GDP doesn't budge, velocity must be in decline. 

M2 Money Supply:

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

The combination of large fiscal stimulus, which included direct household payments, and large-scale QE contributed to the largest surge in M2 growth defined on a year over year basis. 

Any analysis of money supply is incomplete without analyzing where the money is coming from and where it is going. 

M2 Money Supply: Year over Year Growth (%)

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

The velocity of money, the equally important counterpart to money supply, collapsed at the commencement of these new large programs, but the decline isn't a new trend. Velocity has been declining for many reasons, with only time in this note to cover the monetary causes. Velocity has been in a steep decline and will continue on this path due to demographics, debt, and weak investment prospects (physical investment, not financial investment). 

Velocity of M2 Money:

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

The largest year-over-year surge in money supply was coupled with the largest year-over-year decline in velocity, the net result being little inflation. 

In other words, GDP is constrained in the long-run by the number of people working (population) and how productive those people are. 

Pouring more money into this equation does not change the number of people working, nor does it change society's aggregate productivity unless a lack of capital was a binding factor. 

Velocity of M2 Money: Year over Year Growth (%)

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

The production function states that aggregate output is equal to technology interacting with land, labor, and capital. Overusing one factor of this production function does not generate better results. In fact, the law of diminishing marginal returns is triggered by the overuse of any factor, and this applies to overusing capital. So when diminishing marginal returns are triggered, or we cross the threshold into "overusing" capital or money supply, we'll get diminishing gains in terms of GDP. 

More money but less GDP will translate into lower velocity. 

There are many ways to explain the decline in velocity. 

The money supply is real, but declining velocity tells us that this new money is not going to generate new goods and services. If it were, GDP would be rising relative to the money supply, and velocity would increase. 

If the money is not moving into final sales of goods and services, where is it going?

When the Federal Reserve engages in QE and takes a bond from the private sector, the Fed increases the reserve balances of primary dealers. These reserves are not counted in the money supply but generally, QE is conducted using the primary dealers as a "pass-through," so a deposit is also created on the bank balance sheet, increasing the money supply. 

For a more in-depth video primer on QE, click here

In short, some non-bank financial institution had a Treasury bond and now has cash in the form of a deposit after the "QE" transaction clears. Most often, this non-bank financial institution will recycle this newly created money back into some other financial asset rather than into goods and services in the real economy, and thus, the money supply increased, but GDP received no boost, so velocity must fall.  

Declining velocity tells us that increases in money supply are not going to goods and services or "final sales," which boosts GDP. The money is rather sitting in financial assets or some financial account.

On the fiscal side, surely direct stimulus checks increase the money supply, but that doesn't mean it chases goods and services. 

If the government increases debt and hands you $100, and you buy shares of the S&P 500, GDP doesn't budge. Velocity captures this on a coincident basis.

For various reasons, incentives, and policy programs, it makes more sense for people/institutions to park money in financial assets or accounts rather than in the real economy. This is not inflationary to goods and services, what the Consumer Price Index "CPI" and other inflation measures like the "PCE" measure. 

The second critical equation to help us solve this money mystery is the money multiplier. 

The Federal Reserve has complete control over the monetary base "MB," consisting primarily of reserve balances and currency in circulation. The Federal Reserve can influence the broad M2 money supply but lacks total control. 

The ratio of M2/MB is known as the money multiplier "m" and measures how much broad money the economy is creating per dollar of the monetary base. 

Various factors influence this ratio, but essentially, when money is being "created" through the credit process, m should rise. When a majority of money is created through QE or non-income generating economic activities, m falls. 

Money Multiplier:

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

When both the velocity of money and the money multiplier fall, we can gain confidence that money is not being created effectively through the credit process. 

When the Fed conducts QE and increases the monetary base (which they control), and a deposit is created on the bank balance sheet, there is a 1:1 increase in M2 and the MB. As more money is created with a 1:1 ratio, this drags the whole money multiplier measure down. 

If the MB increases, but there is a credit effect from new productive loans, then M2 can rise more than the MB, and the money multiplier increases.

When velocity and the money multiplier fall together, that is strong evidence that money is trapped in financial assets/accounts.

In a banana republic, where money is being created and injected directly into the money supply via the central bank, the money multiplier flatlines at 1 as increases in the monetary base are equal to increases in M2 and the "bad money overpowers the good money." 

Moving forward with the idea that GDP is the best economic series we have, let's change the measure of money we use to see if we get a different result. 

If we use M4 Divisa, including Treasury securities as our money supply measure, we see what our new velocity looks like. 

M4 Divisa is a broad aggregate, including negotiable money-market securities, such as commercial paper, negotiable CDs, and T-bills. Including Treasuries can be informative because, in our system, Treasuries are used as money at times.

If we divide GDP by M4 Divisa, we get our new velocity measure which also collapsed after COVID and ticked down again in December.

Velocity of Money Using M4 Divisa Including Treasuries:

Source: CFS, YCharts, FRED | To Expand, Right-Click > "Open Image In New Tab"

If we chop off the COVID decline, we can see velocity in a downtrend, not as serious as M2 velocity, but the messaging and signal are consistent that the increases in money supply are less effective at generating GDP.

Velocity of Money Using M4 Divisa Including Treasuries:

 Source: CFS, YCharts, FRED | To Expand, Right-Click > "Open Image In New Tab"

The same goes for our new measure of the money multiplier. Defining money is very hard, and there are a lot of competing measures. All measures, however, show the same trend of declining velocity and declining credit multiplier.

Money Multiplier Using M4 Divisa Including Treasuries:

Source: CFS, YCharts, FRED | To Expand, Right-Click > "Open Image In New Tab"

In other words, the measure of velocity is not the issue because we can stack up any measure of "money supply" against our most reliable measure of nominal GDP, and the results are directionally the same. Even when using M4 Divisa, including Treasury securities to capture the velocity "of collateral," yields results that indicate we are generating less output per unit of money. 

The new money is not flowing into goods and services but rather is trapped in financial markets/accounts and or simply contributing to an increase in GDP in a significantly reduced way. 

If $1 trillion of new money is created and stored in a lockbox and never allowed to leave, is that money "chasing" goods and services? No, so this would not create consumer price inflation.

Forming an analysis of consumer inflation based solely on money supply without consideration of where the money originated and where it is likely to move/stay is incomplete and likely why the persistent decline in velocity has been frustrating to watch. 

Household assets of real estate and equities are now 400% of total GDP, highlighting the probable holding place for the new money creation.

Household Assets (Equities & Real Estate) to GDP Ratio:

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

There is a major advantage of being an asset holder in a world where new money is trapped in financial markets. The problem for the economy as a whole is that the wealth effect is negligible, particularly for the ultra-wealthy, and thus aggregate GDP per capita is not impacted. 

Real GDP Per Capita: 20-Year Annualized Rate:

Source: BEA, EPB Macro Research | To Expand, Right-Click > "Open Image In New Tab"

The last two decades came with spectacular booms in asset markets, yet the standard of living, defined as real GDP per capita, only increased 1.2% per annum, thus proving that rising asset markets are not a sufficient condition for broad economic progress.

When looking to solve the money mystery, first look to understand where and how the money is being created, and next look to identify where the money is being used or parked. 

All M2 is not created equal. 

Today's Inflationary Surge - It's Not Money Supply

Make no mistake, over the next several months and through the summer, data for economic growth, and particularly for inflation, will be explosive, but a surging money supply does not primarily cause the increase. 

A series of several idiosyncratic factors are contributing to an explosion in the rate of inflation, all of which will prove temporary or transitory in several years. 

First, consumer spending patterns changed suddenly and forcefully. The radical shift from consumption of services, which require little to no inventory, to durable goods created a worldwide squeeze on raw materials and parts. 

Second, a rapid demographic shift from cities to suburbs caused a one-time surge in housing demand which amplified the demand for durable furnishings. 

Thirdly, this surge in demand for durable goods and the need for an abundance of raw materials is colliding with damaged supply chains due to varying COVID lockdowns and social distance policies. 

Lastly, the comparative base effects over the next several months set up for a large spike in year-over-year inflation without the added pressure of the first three points. 

This cocktail of a rapid change in consumer demand on a worldwide scale into damaged supply chains is leading to a forceful surge in the price of goods. Note the surge in prices is not in both goods and services, but rather only goods. 

Let's analyze the sequence of events leading to this surge in inflation pressure. 

Charted below is the relative ratio of durable goods consumption to service consumption. When the line is moving lower, durable goods consumption is increasing at a slower speed than service consumption. This secular decline makes sense as the US economy has shifted to a service-based economy over the past several decades. 

Shift In Consumption Patterns: Durable Goods vs. Services

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

It is hard to note the change in trend on the long-term chart due to a very forceful secular trend but zooming in on the last 5 years shows the rapid shift away from services consumption and towards durable goods consumption at the start of the COVID recession. 

Consumers were asked or forced to stay at home, and consumption of services fell sharply. As consumers outfitted new home-office space and generally stocked up on goods that can be consumed at home, the demand for durable goods exploded. 

This shift happened globally and all at once. 

It is disingenuous to suggest that fiscal stimulus did not aid this surge, but the shift was more mechanical than as a result of new stimulus payments. 

Shift In Consumption Patterns: Durable Goods vs. Services

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

This change in spending patterns is counter to the secular trend of less durable goods, and we can see this in the chart of household assets of durable goods relative to GDP. 

For decades the demand for durable goods was falling relative to total output, and suddenly that changed instantly. 

It will take time for the effects of COVID to fade and for consumption patterns to normalize, but once consumers are comfortable engaging with the services economy again, consumption will shift away from durable goods and back to services. 

Consumers cannot consume both services and durable goods at elevated rates because consumption over the long-run is constrained by income. Thus once we see the demand for durable goods fade, the inflationary impulse will begin to subside. 

Household Assets: Durable Goods As A % of GDP:

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

Moreover, this sudden surge in demand for durable goods caught suppliers and producers completely off guard. In 2019, no firm had forecast and stocked inventory to account for a doubling in the rate of some durable goods consumption. 

As a result, new orders came pouring in and depleted inventory of basically all durable goods. 

Anecdotally, everyone has stories of durable goods that have multiple weeks or months backlog.  

The chart that captures both sides of this story, new orders (demand) and inventories (supply), is the relative ratio of new orders to inventory from the widely respected ISM Manufacturing report. 

Converting this diffusion index into a growth rate shows the rapid change in trajectory as manufacturing companies had exploding new orders and no inventory to fill the temporary spike in demand. 

New Orders To Inventory Ratio: Growth Rate

Source: ISM, EPB Macro Research | To Expand, Right-Click > "Open Image In New Tab"

So, what happens when every manufacturing company around the world has surging new orders but no inventory? They need to build more inventory!

In order to build a manufactured good generally requires raw materials and commodities, so we saw a commensurate rise in the price growth of raw commodities. 

The rise in price growth for commodities was amplified above the abnormal demand due to badly damaged supply chains due to COVID lockdown restrictions. 

Commodity Price Growth:

Source: CRB | To Expand, Right-Click > "Open Image In New Tab"

We can confirm that most of the price pressure is coming from damaged supply chains by reading the February commentary from respondents to the ISM Manufacturing survey. 

Almost all comments relate to supply chain disruptions. 

Confirmation From ISM Commentary:

Source: ISM | To Expand, Right-Click > "Open Image In New Tab"

The prices paid component to the ISM report, again converted into a growth rate, shows an accelerating trend with the fastest six-month increase in price growth since 2010, uncoincidentally the last time the global economy had a major snap-back pent-up demand recovery. 

ISM Prices Paid: Growth Rate

Source: ISM, EPB Macro Research | To Expand, Right-Click > "Open Image In New Tab"

Virtually all the current inflation and the impulse over the next several months will come from the commodity and durable goods categories. 

Below is the long-term trend of goods inflation to services inflation. 

Again, when the line is falling, durable goods inflation is rising slower than services inflation.

A perpetual decline highlights that services inflation has driven price growth over the last several decades while durable goods inflation has weighed on total inflation. 

Goods Inflation vs. Services Inflation

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

The secular trend is so powerful it can be hard to see the trend change on a long-term chart, but zooming in and plotting the relative ratio in year-over-year terms highlights how today's surge in inflation is entirely from the durable goods sector for the reasons we've outlined above. 

Goods Inflation vs. Services Inflation: Year over Year Change (%)

Source: FRED | To Expand, Right-Click > "Open Image In New Tab"

To argue the current inflationary spike will be sustained for years to come means you'll have to argue that the demand for durable goods will continue at this current artificially elevated pace, manufacturers will not add capacity, and supply chains will stay damaged for years to come. 

If durable goods demand normalizes in 2022, let alone falls after millions of consumers already purchased new couches, grills, desks, refrigerators, automobiles, and more, then inflation will face a headwind. 

If manufacturers and producers add capacity to deal with the transitory surge in new demand, and then consumption patterns normalize, many will be stuck with excess capacity and underutilized resources, again creating a headwind for inflation. 

The combination of a radical shift in consumer spending patterns, a total depletion of global inventory, a simultaneous restocking process into damaged supply chains, and very easy comparative base effects are a potent inflationary cocktail that could generate year over year consumer prices near or above 3.5%.

The chart below shows the path of year-over-year CPI inflation under three scenarios: average monthly inflation over the last ten years, a 10% increase in average monthly inflation, and a 20% increase in average monthly inflation. 

CPI Inflation W/Base Effect Estimate:

Source: BLS, EPB Macro Research | To Expand, Right-Click > "Open Image In New Tab"

In 2015, year over year CPI readings were negative, and this did not mean persistent deflation in the same way that a transitory spike to 3.5% or more does not means sustained hyperinflation. 

Furthermore, in all cases, even if monthly inflation sustains a 20% increase over the historical average, the rate of CPI inflation still falls near or below 2% moving into 2022. 

Today's inflation spike is large and powerful, and adjusting portfolio position has been and continues to be appropriate, but the sources of the inflation should be noted at the root cause rather than jumping to the conclusion of MMT-induced inflation for years to come. 


Record increases in money supply growth have given rise to a forceful narrative of sustained inflation. 

Upon review, the increases in money supply are not generating or "chasing" goods and services but rather staying trapped in financial markets/accounts, which have pushed asset valuations to record levels. 

Holders of financial assets have benefited from these actions, but empirical evidence for the trickle-down wealth effect, translating increasing asset prices to stronger consumption, is lacking. 

New money is not being created through the productive credit process but rather through a 1:1 increase in the monetary base, which is causing a decline in key monetary variables. 

Today's inflationary impulse is very real and will last at least through the summer. A combination of a radical shift in consumer spending patterns, depleted inventory, damaged supply chains, and easy comparative base effects set up for a surge in inflation. 

The best way forward is to follow the cyclical leading indicators of growth and inflation, for when the vector of nGDP growth turns lower, disinflationary assets will once again return to their long-run trend as interest rates move to secular lows. 

It will take time for this inflationary impulse to ripple through the economy, and maintaining an underweight stance on duration remains appropriate, but the root cause of today's inflation is not grounded in new secular trends. 

We maintain a heavy focus on cyclical manufacturing indicators specifically for this reason. Despite its shrinking size in the US economy, the manufacturing sector has volatility that greatly exceeds the service sector and remains responsible for the largest change in the rate and direction of nominal GDP growth. 

The growth and inflationary upturn will continue, and the cyclical leading indicators will guide the short-term path forward. 


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