Yesterday was a day where yet again we saw extreme moves in equity markets and to an extent currency markets too. European equity markets had opened lower and the main 3 of the FTSE,Dax and Cac 40 were all falling by around 2%. Then we saw a rally around the time of the opening of US markets and in the end the FTSE for example only fell by 25 points or 0.5% which when you allow for BP’s current problems means most shares were in fact up. However this morning shares are falling fairly heavily again with the main 3 European equity markets down by 1.5%. As I wrote on the 26th May these are very difficult markets for the private investor. With the time lag that takes place between instructing a pension or investment fund and it operating those instructions such volatility and uncertainty means that trades may take place at quite different prices or levels to those intended. As to someone vesting a pension fund with all the administrative delays that can take place it must be at best frustrating.
European Money Supply
I was asked a question on this subject and thought that I would update further on it because what is happening with the euro zones money supply is indicative of what is also happening in the UK and US. On Monday new figures for money supply growth were published and they were as follows. The European Central Bank has 3 measures of money supply but the 2 main ones are the narrow one M1 and the wider one M3. Their annual growth rates for April were 10.7% for M1 and -0.1% for M3. In a nutshell those figures explain the problem of being a central banker in these times as you can pump money into the system which will impact on your narrow money measure (M1) but wont affect your wide measure (M3). The ECB is far from alone in this as UK and US money supply measures have similar themes. In essence they can force cash into the system but they cannot get people to borrow (or perhaps more accurately banks to lend).
I wish to expound on this subject and explain some more. When the credit crunch began the wider measure of money supply was growing much more quickly than the narrow. Even in 2008 as a whole we saw M3 grow by 7.6% and M1 grow by 3.4% and this includes a slowdown at the end of the year as the credit crunch began. However you could define the boom that came before by money supply growth and in its latter stages M3 growth exceeding M1 growth. This reflects the credit expansion that came before the crunch. However this changed in 2009 as annual M3 growth was -0.3% in its last quarter but annual M1 growth had risen to 12.4%. What we are seeing here is a central bank responding to a credit crunch.
What did the European Central Bank do?
The first move by a central bank is to cut interest rates and the ECB’s main refinancing rate was cut by a cumulative 325 basis points between October 2008 and May 2009 bringing it to its current level of just 1%. This is a level not seen in the countries of the euro area since at least the Second World War. However this was not enough in its view and so it undertook some non-standard or extraordinary measures which it calls “enhanced credit support”. These were or are.
1.Fixed rate tenders with full allotment in all liquidity-providing operations.
2.Additional refinancing operations with one-month and three-month maturities, as well as the provision of funding at longer maturities of six months and one year.
3.A broadened collateral framework, notably the lowering of the rating threshold to BBB- and the acceptance of selected foreign currency assets and of securities issued in some non-regulated markets, all these with commensurate additional risk control measures. (Putting this in English the ECB would supply liquidity (cash) in return for lower quality assets than previously)
4.The covered bond purchase programme (approximately 70 billion Euros worth).
5.The introduction of foreign currency-providing operations.
6.More recently can be added the purchase of sovereign government debt.
I wish to just re-emphasise how extraordinary the measures above are. But money supply did not respond as expected for the ECB was able to affect the narrow version M1 which is growing in double-digits but the wider measure M3 did not respond as expected and is still negative.
If we look at the definitions of the two measures we can see the root of the problem. M1 is currency in circulation and overnight deposits. This is easy to influence by a central bank. M3 adds to the definition deposits with an agreed maturity up to 2 years, deposits redeemable at a period of notice up to 3 months,repurchase agreements,money market fund (MMF) shares/units and debt securities of up to 2 years. These extra factors have proved very difficult to influence and if you remember that the M1 component of M3 is growing strongly it must be that the others are in fact shrinking by more than the total growth rate of -0.1%.
The monetary system was represented many years ago in the simple formula of MV=PT. Where M represents the stock of money, P is the price level, T is the amount of transactions carried out using money, and V is the velocity of circulation of money. There are variations in this quantity theory of money but if you look at what is happening now in such terms then it is V or the velocity of money which has changed. Furthermore it has changed such that central banks seem unable to adjust the balance even by raising narrow measures of money supply quite substantially. As fast as they raise M they seem to be finding V falling.
Whilst the equation is a little simplistic it does highlight the problem.
The problem is worldwide
If you look at broad money growth in the UK (we call it M4) then growth is also around zero,for example the UK headline M4 money supply growth was flat on the month in April, in the US the chairman of the Federal Reserve Ben Bernanke has got so frustrated with the growth figures for the wide measure of money supply (M3 for the US) he has said he will ignore it. One can argue over what aggregate to use but there is a disturbing trend in US M3 where it has fallen heavily recently. Whilst the Federal Reserve no longer publishes M3 statistics it still publishes the underlying data and M3 is currently falling quite rapidly,in the latest figures for the three months to April it was falling at an annualised rate of 9.6%. There are differing explanations for this but the fact remains it is falling.
The transmission mechanism of monetary policy has changed over the period of the credit crunch as we have been reminded that increases in narrow money can be provided by a central bank but for this to be reflected in wider monetary aggregates then this process is conditional on the private sector’s appetite to borrow. We had got so used to a thirst to borrow that I think it became an assumed part of the environment and little thought was given to what might happen if it declined or ended. Once a central bank has pumped money into an economy then for “wide” money to be created we need private commercial banks to grant credit to private agents in response to the provision of reserve or high-powered money by the central bank. The problem in the euro zone at this moment in time as well as the UK and US is that due to the prior over-leveraging of private sector balance sheets, there is almost no appetite to borrow (in aggregate), and hence monetary policy is unable to play its normal role of providing new credit and simultaneously expanding the stock of broad money in the economy. This is why broad money growth rates in Europe the US and the UK are currently all close to zero, and in some cases negative. Until private sector balance sheets have been de-leveraged and the appetite to borrow has begun to return then it is unlikely we will see any great improvement.
More simply I think that the banks are taking the liquidity and using it to repair their own balance sheets to some extent so the banking multiplier one might expect is not happening. Now here is a question for you to think about. If you knew in advance what would happen in terms of the effectiveness of monetary policy would you if you were a central banker have done what they have in terms of a raft of extraordinary measures?