Leading Economic Indicators

The Conference Board publishes various lists of Business Cycle Indicators. Those indicators are categorized as leading, coincident, or lagging. This post will take a look at indicators 6 through 10 on the list of leading economic indicators. Indicators 1 through 5 will be covered in a second post at a later date.

Leading Indicators

1. Average weekly hours, manufacturing
2. Average weekly initial claims for unemployment insurance
3. Manufacturers’ new orders, consumer goods and materials
4. Vendor performance, slower deliveries diffusion index
5. Manufacturers’ new orders, nondefense capital goods
6. Building permits, new private housing units
7. Stock prices, 500 common stocks
8. Money supply, M2
9. Interest rate spread, 10-year Treasury bonds less federal funds
10. Index of consumer expectations
    

S&P 500



Looking at the above chart I find it hard to believe that anyone thinks the stock market is a valid indicator of anything.

Starting in 1960 and using a decline of 10% as some sort of leading indicator would have generated five false positives, one miss, and one success. At the start of the 1980 recession the S&P was up year over year about 5%, at the start of the 1982 double dip recession the S&P was up close to 30%, at the start of the 1991 recession the S&P was up over 10%, and at the start of the 2001 recession the S&P was nearly flat. The S&P did not decline 10% before during or after the 1960 recession. As a coincident indicator the results would have picked up 1982 and 1991 but would still have missed 1960 and 1980. In 1987 and 2003 the stock market declined nearly 20% but there was no recession.

Just for fun let's take a look at the Dow Jones Home Construction Index



Did the above chart "lead anything" or did the index peak a month or so after the June 13th 2005 Time Magazine Home $weet Home cover?

Time and time again I hear "The stock market acts six months in advance" Six months in advance of what? I fail to see how it is acting six months in advance of anything. If one is looking for leading economic indicators, the stock market is surely not one of them.

Also note that if one wants a stock market indicator the economy is surely not it. Look at the plunging GDP in comparison to the stock market for recent proof. Look at the homebuilder chart above for recent proof. Look at the historic S&P 500 chart for proof. Seriously, the S&P is a hopeless leading economic indicator and the economy is an equally hopeless stock market indicator.

Yet the myth (and the weighting) that the stock market is a leading indicator still persists. It's no wonder that nearly everyone is confused given that nearly everyone is looking for correlations that simply do not exist.

Consumer Sentiment



This chart of the University of Michigan Consumer Sentiment Index seems to have some merit as a coincident indicator but little as a leading indicator, at least in the timeframe for which this data is available. The indicator also suffers from what seems to be a high percentage of false positives per correct call. As a coincident indicator it has 3 false positive and 4 successes. One could draw the trigger line differently to avoid the false positives but then the big recession in 1982 would be missed entirely.

Housing Permits



Seven out of the last eight times the annual rate of change on permits was negative 20% or lower, the economy went into a recession (not counting the current situation). Currently the chart shows that building permits in November dropped 31% from the year earlier level.

In all seven recessions since 1959 building permits declined year over year. Using the 0% line as a threshold would have picked up the recession in 2001 but would have also resulted in false signals in 1965, 1985, 1987, and 1996 as well. This can be summarized as seven out of seven with four false positives.

Using 20% as the threshold the only false signal was 1987 but there would have also been a missed signal in 2001. This can be summarized as six out of seven with one false positive and one miss.

This is actually a reasonably good performance, especially if one uses a cross of the 0% line as a strong warning signal while waiting for continued confirmation. Note that dips below the 0% line tend to occur well before the onset of recessions. Leading indicators are supposed to lead and this one does. A crossover of 0% is a strong warning and a continuation below the zero line shows that a recession is likely.

Money Supply

In Money Supply and Recessions I introduced M' (M Prime) as a leading indicator based on sound Austrian principles and definitions of money. Those who have not seen how or why I came up with M' can click on the above link to see just what M' is all about. What follows now is a recap of M' vs. M2 as a leading indicator.

M Prime



Leaving the current status as unknown, 6 of the last 6 recessions were marked by a major dip in M Prime. Note how the indicator clearly led the recession. Also note that 6 of 8 sustained dips below an annual growth rate of 5% in M' led to a recession. On that basis we have 2 potential false signals (1985 and 1995).

M2



Unlike M', the direction of M2 does not seem to give clear economic signals. Note that M2 was rising into the double dip recession of 1982 and rising into the 1991 recession as well. Also note that the single largest dip in M2 was in 1993 while M' was soaring. The years between 1992 and 1995 are all problematic. Finally note that unlike M' where a dip below 5% annual growth was a huge warning sign, the dotted line above shows no such significance. M' seems to be far superior to M2 as a leading indicator.

M Prime CPI Adjusted



On a CPI adjusted basis we see that there has been a recession on 6 of 7 sustained dips below the zero line of year over year growth in M'. The 1985 excursion below 0% was extremely brief in stark contrast to all of the labeled recessions and thus can be discounted. 1995 is still a miss but nowhere near as pronounced as compared to M' unadjusted. 1995 also happens to correspond to the start of a huge ramp-up in sweeps. Perhaps that is significant and perhaps not. Nonetheless, M' CPI adjusted gives a cleaner signal, arguably calling for 7 recessions of which 6 happened.

The above chart clearly shows M' CPI adjusted to be a strong leading economic indicator.

M2 CPI Adjusted



M2 CPI adjusted is certainly an improvement over M2 CPI unadjusted. Note however, that the 1982 and 2001 signals are not as strong as the corresponding M' CPI adjusted signals. The M2 adjusted signal for 2001 was particularly weak. More problematic for M2 adjusted vs. M' adjusted is the mass of jello between 1988 and 1996. M' adjusted was clearly giving an "all clear" zero cross signal by 1992 while M2 adjusted gyrated for years and did not really give an "all clear" until 1998. Furthermore M2 adjusted actually dipped back below the zero line in 1997 while M' adjusted was soaring upward. Both M2 and M' missed around the 1996 timeframe but even here M2 did worse both in terms of an actual low and the jello that preceded it.

10yr Treasury minus FF Rate Spread



A dip below zero preceded 6 of 6 recessions since 1965. Unfortunately it generated 5 false positives as well. Of course one can set the line at -1 in which there were only 3 false positive. Or one can set the line at -2 in which case there was 1 false positive and 1 miss. Still, it would be much nicer if we did not have such curve fitting. Can we do better than this indicator?

The Yield Curve



The above chart was generated by subtracting the symbol $IRX from $TNX where $IRX is a 13 week discount and the latter a 10 year yield. Ideally both would be yields but the difference is not that great on the the 13 week. We we use free data when available, and that data not only works well it also happens to be free.

This chart is almost perfect. A three month to 10 year inversion is 6 for 6 with one false positive in 1966. The current situation is considered unknown.

Note how the above chart does not confirm the false signal on the 0% line cross in 1995 of the previously shown real (CPI adjusted) M' chart. Unfortunately the false signal in 1967 on this chart predates the beginning of our M' series of charts, but I suspect there was non-conformation in the other direction, with M' not confirming the this chart.

Comments From Paul Kasriel

• The "real" unadjusted monetary base (bank reserves plus currency) seems to provide fewer false recession signals than does real M2 growth. That does not necessarily mean that the real base does a better overall job of forecasting real GDP, just that it does a better job of forecasting official recessions. Mish notes: "Real" in this case means inflation adjusted via the PCE price deflator, and "unadjusted monetary base" means a non-seasonally adjusted monetary base.
• I have used the PCE price deflator to get "real" rather than the CPI for purely arbitrary reasons here, not theoretical -- I don't have time to explain now, but it is not a big issue. Mish note: There is a potentially confusing mix of terminology here but none of the charts in this post were seasonally adjusted (except perhaps for consumer sentiment and on that I am unsure). Our inflation adjustments used the CPI, and any references to "real" in what I wrote (as opposed to what Kasriel wrote) means CPI adjusted. As Kasriel suggests there is little difference between the two. We tried both and settled on using the CPI because that that is what Shostak did as explained in Money Supply and Recessions.
• Starting with the recession of 1970, a negative spread on the 10-yr Treasury minus the fed funds rate in conjunction with a contracting year-over-year change in monetary base/CPI has predicted recessions with no false signals. In Q3 and Q4 of 2005, the real monetary base contracted but the interest rate spread still was positive. Now, the interest rate spread has turned negative, but the real monetary base is no longer contracting -- just barely. Mish note: The 10yr minus the 3 month spread by itself has no false positives and no misses since 1970.
  

Final Thoughts

• Real M' is a very good leading indicator. It also performs better in theory and practice in comparison with Real M2. Real M2 performs better than M2, and M' performs better than M2. M' is thus a better indicator than M2 no matter how it is compared (real or not).
  
• The 10yr minus the 3 month is an exceptional leading indicator. It works better in practice than using the 10 yr minus the FF rate.
  
• No false signals were given by the 10yr minus the 3 month spread since 1970. False signals were given by spreads using the FF rate alone.
• No false signals were given by a combination of Real Monetary Base and the 10yr minus the FF Rate spread (as per Kasriel but not shown).
• Housing permits provide a valid leading signal. When the 0% line is decisively penetrated, a recession usually follows.
  
• The S&P 500 is simply not a valid leading economic indicator. It is at best a marginal coincident indicator and perhaps should be ignored altogether. There are just too many false and/or missed signals.
  
• Consumer sentiment may have some value as a coincident indicator but it does not function well as a leading indicator.
  

This post is an attempt to find a methodology that makes theoretical sense and works well in practice too. Five of the ten widely used leading indicators were reviewed, one of which should be discarded outright, one redefined as a coincident indicator, one (housing permits) is valid as it stands, and two leading indicator components had substitutes that seem to work far better in both theory and practice.

The charts show that M' and the 10yr minus the 3 month spread are both superior to similar indicators that are on the list. As time permits, I will take a look at the remaining 5 widely used leading indicators. Thanks once again to Bart at NowAndFutures for providing many charts based on specifications that I requested, and also to Paul Kasriel at the Northern Trust for his time and comments.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Friendship Lost

This post is a further continuation of the "Saga of Sonnypage", an Atlanta area real estate broker who posts on my investment board the Motley FOOL.

Previous Sonnypage highlights include:

Lights Out in Georgia ...on 2006/07/27
Soft Market Debris ....... on 2006/08/02
Is the Fed irrelevant? ...on 2006/08/03
Scared in Atlanta...........on 2006/08/06
Time Keeps on Ticking..on 2006/08/27
Two Anecdotes ..............on 2006/09/15

Friendship Lost
Sonnypage 2007/01/12

The origins of "Friendship Lost" go back to a Sonnypage post made on the Motley FOOL on 2006/12/08. Let's pick up the story from Sonnypage:

My wife and I are Realtors who live and practice real estate north of Atlanta, out in Roswell and Alpharetta and further north into north Georgia. This past week has been the most unusual and unanticipated in our fourteen years in the business.

We have known Stuart and Amanda for many years. It was five years ago that we helped them sell their older home and buy a new home in Alpharetta. Two months ago, Stuart called me to ask if we could help them find and buy a “weekend house” up on Lake Lanier. Did we work up there? I explained that we did and that more and more of our business has been shifting to north Georgia. The baby boomers are looking for places to retire that are warm, beautiful and have lower taxes. North Georgia and western North Carolina have been experiencing quite a boom.

So we started our search. Keep in mind that this would just be a second home for get away weekends in the summer. We quickly learned that $300,000 did not get us much and moved up to the $400,000 range. Even here, we learned that the most important factor was access to “deep water”. So many of the homes we checked out advertised as being “on the water”, but when we got there, what we saw was a mud flat down below the house well down the hill. Water levels on Lake Lanier depend on rainfall plus how much water is released through Buford dam for Atlanta. Having a good lot on deep water is hard to find but more important by far that the actual house itself. Finally, after a long search, we found a decent but smaller home on a fantastic lot. We had great deep water plus a quality dock. Dock permits are limited and only 300 more will be allotted. So, the lesson is that deep water and a dock is very important, the house on the lot much less important. We went under contract and did our inspection. The inspection revealed a foundation crack and the contractor estimate was $5000. The seller offered to pay only $2500 of the cost to repair. That was when our deal came apart. Stuart went on a rant about how the seller was “unethical”. “I don't want this house”. We heard that three times. It seems that Stuart's sister was a Realtor in another state and she had been advising him. “The seller was being unethical”, she told him. We told Stuart that we thought the house was under priced. The seller was doing a “1031 tax exchange”. He had obviously found a higher priced home that he thought was under priced and wanted to buy it. To take advantage of this, he was also, we thought, prepared to sell his current home for less than it was worth. Stuart was having none of it. By now his ego and emotions were firmly in control. He no longer “wanted to deal with the seller”. Stuart won the argument but lost the house. We submitted a termination and release which the seller promptly signed.

I contemplated the turn of events all day in disbelief. Stuart, you let your emotions cost you a great deal. Based on all of the total garbage we had looked at on the lake while searching with Stuart and Amanda, my wife and I were convinced that they had let an incredible bargain get away from them. It took us one day to decide to buy it ourselves. We submitted an offer for $2500 more than Stuart's last offer, but again asking the seller to leave $5000 in escrow for that foundation repair after closing. They accepted. We close January 31st. Only a week ago, I was not even considering buying a second home on the lake, but here I am.

Of course, if the housing doomsayers are correct, if the slide in housing prices is just gathering steam, if a recession in 2007 is looming, then I have just stepped in front of a speeding train. My actions speak for themselves. Housing prices are bottoming and there will be no recession in 2007. More importantly, areas where the baby boomers will be retiring are just in the opening innings of a major boom. We have made an outstanding long term investment. In five years, when our youngest heads off to college, we will sell our Roswell home and retire to Lake Lanier. By then, we can roll our weekend house there into a year around house.

This year has been the slowest year we have ever experienced in real estate with only 14 deals compared to the 26 deals a year we have averaged over the past five years. But 2007 is already off to a strong start. We have already booked three large transactions that will close next year. I anticipate a very good year.

Sonnypage

I replied to the above post on the Motley FOOL with:

What I do not get is that the quibble seemed to be over $2,500.
Let's see ...
The home was in the $400,000 range
A 6% commission would be $24,000 would it not?
I can not figure out who in their right mind, given the slow nature of real estate right now, who would not put up the $2,500 and rush the deal to the table ASAP.

I also do not understand the owner quibbling over that same $2,500 but I would expect that if that is all it was, for the real estate agent to be happy with $21,500 instead of $24,000 or even $15,000 for that matter, just to get a deal done.

This elicited a response from "Inparadise" another real estate agent on my board who replied with....

Wrong. He has not lost his buyer, who will most likely buy something else at a similar price down the road, to which Sonny will be entitled his full commission.

Sonny's chances of selling that particular house may have been small, but his chances of selling another house to his buyer, not at a discount to his commission, large. He did not give up a chunk of commission, but postponed it until his buyer finds another place and in the mean time netted himself an investment that his buyer voluntarily passed up.

To which I replied ...

It MAY happen but "large chance"?
How many chances did Sonny have this year and how many fell thru?
In this case not only did it fall thru but sonny did not budge all for a lousy $2,500. If I was that buyer and I found out that Sonny bought that house, his odds of working with me ever again would be ZERO.

To which Inparadise responded ....

Yup, large chance: They have already done at least two transactions together. There is a large chance that they will do more.

And Sonnypage chimed in with...

We have known Stuart and Amanda many years. They will take the holidays to cool off and most probably call us after the holidays to start looking again. We have not told them what we did but Stuart will just laugh, I assure you. He's a little bit of a hot head which does not help in negotiating anything. Never fear, we will find them another great house.

Story Resolution
From Sonnypage 2007/01/12

After the holidays, Saturday, January 6th, we met them again at our usual parking lot rendezvous to go up to the lake to look at two properties. As we pulled out of the lot, my wife mentioned casually that we had personally put the home they had terminated under contract. An instant chill filled my car. Amanda said that was great and continued to chit chat with my wife in the back seat, but Stuart, sitting beside me, said not a word all the way up to the lake. The first home we looked at was priced at $499,000, was slightly larger than “our” home, had decent water but a run down dock. Stuart still had little to say other than commenting on the poor deck. We made our way to the second home we had planned to see and as my wife opened the door, Stuart and Amanda headed down to check out the water and dock. We gave them a few minutes and then headed down to join them at the dock. As I got there, Stuart turned to me and said, “Sonny, I think your buying that house was unethical and we are really upset with you. We no longer want to work with you and Tori”. I tried to talk with him, I said I had no idea they still had an interest in that home, I offered to “assign” the contract to him. As he headed up the hill to our car, he said over his shoulder, “I don't want that house”. As we drove back to Atlanta, Tori tried to strike up a conversation with Amanda, but Stuart said not a word. We returned to their car, they got out, Amanda told us goodbye but Stuart was still silent.

On Tuesday, we were working from home in our office there. Our managing broker called to say that she had received a letter from Stuart and Amanda. She faxed it to us at home. They started by saying, “We are writing this letter to bring to your attention a recent transaction that we believe to be in conflict with the Realtors Code of Ethics regarding our real estate agents”. They then named us and then sited Article 5 of the National Association of Realtors Code of Ethics which reads:” Realtors shall not undertake to provide professional services concerning a property or its value where they have a present or contemplated interest unless such interest is specifically disclosed to all affected parties”. Our managing broker asked us to respond to their allegations with an email to her and another party at our firm, and then meet with her the next afternoon to discuss. I reread Stuart's long letter carefully. It was mostly a rehash of everything that had transpired from start to finish, but bottom line, one thing was clear. They were convinced that we secretly wanted this house for ourselves while we were negotiating on their behalf, and because of this had not “negotiated diligently enough on (their) behalf”.
In my email to our managing broker, I closed in part with this: “I want to make it clear that at no time while (we) were working with the ****** were we even remotely considering an immediate purchase of a lake house for ourselves...........It was only the next day, after the ****** terminated what we thought was a great deal and we could find no other buyer, that we thought of buying the property for ourselves”.

The next afternoon we met with our managing broker. We were told that we had done nothing improper. She reminded us that as long as that property is on the market, it is available for purchase by any qualified buyer. We discussed several scenarios, all of which would be perfectly legal. What if we had another set of buyers also interested in lake property and they wanted to make an offer simultaneously with Stuart and Amanda. Should we make that offer? Absolutely, and the listing agent is obligated to present all offers. Any agent is free to make an offer on behalf of their clients, or in the case of other agents, on their own behalf as well. It would only be if Stuart's allegations were true would there be an ethics violation. If we were indeed considering the house for ourselves, as Stuart suspected, there would be an issue. But that was not the case. If this ever came to litigation, the listing agent would testify that we had not indicated a personal interest in the property to her until almost a full day after the termination and release by Stuart had been signed by her seller. Our interest could not have impacted his willingness to terminate with Stuart. Also, his bottom line with us was the same as it would have been with Stuart. We in effect accepted the deal they terminated.

When my wife met Stuart and Amanda that Friday morning, she tried to convince them to counter offer on the inspection amendment. Stuart was having none of it, “I don't want that house”, he said that repeatedly. He was angry at a seller who would not agree to a repair that would cost that seller an additional $2500. Stuart is guilty of not being able to see “the forest for the trees”. After we were under contract, I asked our mortgage lender to have a conservative appraiser, familiar with lake property, do the appraisal. I wanted to be very sure, in my own mind, that this was as good a deal as I thought. The appraisal came in yesterday at $450,000. We have an immediate gain of $30,000 before we even close. So why is this such a good deal? Is the seller unaware of the true value of his property? Not at all, this is, as I mentioned in my last post, a 1031 tax free exchange. What the seller is losing by selling this property below value he more than makes up in saved taxes. He has already “identified” a property priced at $1.2 million that he wants and that he must think is a great value.

My wife and I and Stuart and Amanda have all lost something though. We have known them and called them friends for eighteen years now. But that is, as my wife said, “over now”. Too bad, but then, I have never been called unethical in all my years in business. Stuart, you have a temper, and this time you have said things to me, and believe things of me, that no friend would say or believe. You are no friend of mine. Sue me if you will, you will lose, and we will close in two weeks. I drove up to “our” lake house this morning. Our insurance company wanted to know the location of the nearest fire hydrant. There must certainly be an easier way to have found that out but I really wanted an excuse to drive up there. The lake is up from all the rain and that lot looks more beautiful all the time. When we retire in a few years, I can see tearing down that little cottage and building a real house. It's strange how things work out. It's really beautiful up there.

Sonnypage

Wow.
Given that I consider Sonnypage a friend (I hope he still feels this way after this post) I would rather have been wrong than right. I do not know the law in this case but I am willing for now to accept that Sonnypage was within the limits of the law.

I am looking for how this could have been prevented.
It seems easy enough to me (but of course hindsight is 20/20).

• If that property was such a great deal, Sonnypage could have snatched it himself before showing it to the client. Why wasn't the value recognized before the initial showing?
• If that was a friend of 18 years whose future business and referrals one could count on, what's the big deal in offering to personally pony up $2,500 to close the deal on a lucrative transaction?
• Rather than offering assignment after the fact when showing another house, why wasn't it offered ahead of time?
• Was all this worth the loss of a friend and associate with all the potential repercussions down the road with legal challenges?

I am not a lawyer but by offering to assign the house I think Sonnypage did a very smart thing. Perhaps it would be smart to offer it in writing with a small deadline. There are no possible damages (that I can see) if that assignment was offered. Still, this all seems too easy to have avoided in the first place, and possibly numerous places along the way.

Good Luck Sonnypage .
I hope this does not result in another "Friendship Lost" but the aftermath needed to be reported and Sonnypage at least stepped up to the plate and did it. Opinions on this transaction are requested from a legal and ethical standpoint. Fire away.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Q&A on the Psychology of Deflation

Following are questions and comments in regards to Significant Shifts In Psychology. The volume of responses was enormous but many of the questions keep getting asked time and time again in response to various posts. I decided to take as many of these questions as I could find, including some from the Motley FOOL and address them in this post that everyone can refer to.

Typically the questions or comments are about cultural differences in Japan, a belief that printing presses can always defeat deflation, that we are in some sort of 70's rerun situation, public obligations will cause inflation, the Fed can reflate the housing bubble, and comparisons to the Weimar Republic. Let me address these questions and comments.

Culture

• Too even compare the citizens of Japan to the US is stupid, stupid, stupid Forest Gump!
• Culturally the Americans are spendthrifts compared to the Japanese.
• Japan's culture is older than 200 years and culturally they are different and it does matter.
• The comparison to Japan is hollow, North Americans have become drunk on excess and will keep spending until the repo vans appear in the driveway.

Mish Reply
Comparisons to Japan are not stupid at all. It is important to understand both current differences as well as trends. The biggest differences are demographics (an aging population and immigration policies) and consumer debt. The former is a deflationary force in Japan, the latter a deflationary force in the US. Consumer debt is an enormously deflationary force when it reaches the point it can not be serviced. We are at that point now and we face additional deflationary pressures of outsourcing and global wage arbitrage.

When it comes to spending one also has to remember that it was not that long ago that the savings rate in the US was 8%. That savings rate steadily declined to the point where it went negative for 18 consecutive months. What can not continue will not continue by definition. A negative savings rate can not continue forever. There will be a trend reversal in the US back towards the norm on savings and sooner or later a trend reversal back towards spending in Japan. After a 20 year bout with deflation in Japan it is too easy to say they are a nation of savers. Likewise after a massive 20 year spending spree in the US it is easy to project that trend forever into the future. Neither trend can last forever. The savings rate in the US has only one way to go and that is up. A reversal towards savings in the US will actually be quite supportive of the US dollar.

As for demographics, notice that the open door policy of immigration in the US shows signs of closing. That is a trend shift with potential implications for future housing demand. If immigration in the US slows, it will slow the need for housing (and everything related to housing). In contrast, Japan will eventually open up to immigration for the simple reason they will have to. Trends change. Both Japan and the US are showing major signs of reversal on many fronts. The deflationary forces are building in the US just as they are slowly receding in Japan. So.... is it stupid to make comparisons to Japan, or stupid to not make comparisons to Japan?

Pushing on a String

The Fed cannot manufacture growth (it will end up "pushing on a string" in the end). The Fed CAN certainly manufacture inflation. There's a big difference b/t the two. Perhaps you are missing it?

Mish Reply
Exactly what is it I am missing? The Fed can print and I never denied it. Whether or not it accomplishes anything depends on willingness of banks to lend and consumers and businesses to borrow. Besides, doesn't pushing on a string imply a failure to create inflation?

Solve Deflation by Printing

The answer to any deflationary whiff is massive printing of dollars. The Fed can use this money to bail out failing banks, bail out failing hedge funds, buy trillions in mortgages. Since the money supply would otherwise be contracting, the result is no deflation. A standstill in money supply growth instead of a big contraction. This is what Mish doesn't seem to understand. All you have to do is look back no further than the early 1990s to see how this works. There was massive deflation in the form of failed S&Ls and real estate and the US basically printed money to bail out the banks.

The banks and hedge funds and large pools of borrowed money will have their hands out for central bank bailouts. The central banks will print massive amounts of money to bail out these institutions. There will be unbelievable demand for money from the big financial institutions. That will result in no deflation whatsoever. The money supply will be contracting but to prevent defaults the central banks will be printing money so the net result will be NO deflation. This has happened again and again and so I'm not predicting anything that hasn't already happened. The big financial houses will be lining up for loans and this will counteract any deflation. Individuals and financial companies will need bailouts to meet their real obligations, and this will be inflationary. Remember, the S&L bailout in today's dollars would be something like $300 billion. That is not chump change.

Mish Reply
If printing cured deflation neither the great depression nor a 20 year bout with deflation in Japan would have happened. I refer you to these comments made by Paul Kasriel in an Interview with Paul Kasriel.

If the banks are unable or unwilling to extend the cheap credit being offered to them by the central bank, then the economy grows very slowly, if at all. This happened in the U.S. during the early 1930s.

U.S. banks currently hold record amounts of mortgage-related assets on their books. If the housing market were to go into a deep recession resulting in massive mortgage defaults, the U.S. banking system could sustain huge losses similar to what the Japanese banks experienced in the 1990s. If this were to occur, the Fed could cut interest rates to zero but it would have little positive effect on economic activity or inflation.

Short of the Fed depositing newly-created money directly into private sector accounts, I suspect that a deflation would occur under these circumstances.

Most people are not aware of actions the Fed took during the great depression. Bernanke claims that the Fed did not act strong enough during the great depression. This is simply not true. The Fed slashed interest rates and injected huge sums of base money but it did no good. More recently, Japan did the same thing. It also did no good. If default rates get high enough, banks will simply be unwilling to lend which will severely limit money and credit creation.

In addition, comparisons to the S&L crisis are invalid. There was an enormous capacity for consumers and businesses to take on credit at that time. Today consumers are financially strapped and businesses have no reason to expand. Overcapacity is rampant and the economy is running on fumes of financial speculation. This is 1929 revisited not an S&L crisis.

Individuals may need bailouts but it is presumptuous to assume they will get them in time if at all. In fact if you look at the bankruptcy reform act of 2005 you will see corporations intending to make consumers debt slaves forever. Oddly enough the bankrupty reform act is doing in practice what some claim culture did to Japan (prevent writeoffs).

The simple fact of the matter is the Fed has no ability to put money into consumers pockets and even if they did, they certainly could not prevent consumers from paying down debts rather than going on a spending spree. Besides, the Fed has shown no propensity to bail out consumers at the expense of banks. Does anyone remember Greenspan's recommendation that consumers use adjustable rate mortgages right at the very low in yields?

Public Obligations

In 2012 social security runs short of revenues; this will be an inflationary force. I'm sure I don't need to mention medicare, the Pension Benefit Guarantee Corporation (a GSE) increasing in obligations as domestic companies go insolvent with respect to pensions, etc.

The entire situation of unfunded liabilities (not only in the U.S.) is likely to become a major political as well as economic problem in the next decade.

Mish Reply
Running short of revenues means that taxes will have to be increased or benefits slashed or alternatives found. None of those are inflationary and I expect some combination of all of those to occur. Already we see medical outsourcing and that trend is in it infancy. That will reduce costs. I also expect the next Congress to allow drug imports from Canada. That will not only lower costs but lower corporate profits as well. As for domestic companies going insolvent, I agree. GM and or Ford are high on the list. That would be a hugely deflationary event (destruction in credit) should it happen.

Medicaid etc will become a huge problem eventually, but first things first. The consumer debt problem is a far bigger problem for the here and now.

Jobs and Wages

Congress can create (useless) jobs. Congress can raise wages. Fannie Mae can revive the housing bubble. Congress can put money directly into consumer pockets (think $1,000 tax credit to every filer). Congress may be willing to cause inflation.

The only variable the government cannot directly affect is consumer psychology. But in wartime, it doesn't have to -- the government can step in as the buyer and borrower of last resort.

Mish Reply
Fannie Mae has no power to reinflate the housing bubble. That notion is just plain silliness. Congress can indeed create jobs. Japan tried that and built a lot of bridges to nowhere. It did not cure deflation but instead took Japanese national debt from zero to 150% of GDP.

Congress can also raise wages. But how many small business will go under if they do? Massively raising wages or putting on huge tariffs to "save US jobs" would both kill US jobs. Loss of jobs is not an inflationary thing in that it will without a doubt increase bankruptcies.

Congress can indeed throw money into people's pockets with still more tax cuts or tax credits. IF they do, would it help the right people? Enough to matter? Once again we come up to the issue of will Congress bail out the little guy at the expense of banks? I suspect not, but they may try something. If they do, will it backfire? I suspect so. The belief in Congress to do something that will work is staggering. The creation of Fannie Mae to make housing more affordable did the opposite. The War on Terror increased the likelihood of terror. Invading Iraq was supposed to free up oil to pay for the war. Did it? We fought the Vietnam War on the Domino Theory. What happened? The Smoot-Hawley tariff was supposed to save US jobs, did it? Exactly what did the "War on Poverty" accomplish? Now all of a sudden there is some massive belief that Congress will do something intelligent and that it will work to stop deflation. I find that amusing.

War Comments

• Japan would probably get out of its deflationary trap easily if it would simply declare war on Malaysia and ramp up defense spending accordingly.
• Can the Fed create jobs? Yes it's called the draft, the oncoming decades of resource wars brought on by peak oil will keep sucking up the more and more desperately unemployed that the Gov is under reporting.
• Can the Fed raise wages? If a million extra soldiers enter the work force, the money does not need to be distributed to the already employed but the newly employed. The effect is the same new spending.

Mish Reply

If Japan declared war on Malaysia I suspect it would immediately collapse the entire worldwide house of cards in derivatives, possibly causing a worldwide recession if not worse.

As for the US, the last I checked the Fed could not declare war. Also the last I checked the people in the US are sick of war and want out of the current one. Of course Bush is ramping up another 20,000 soldiers anyway but those are not new soldiers. Even if those were new jobs, in the grand scheme of things 20,000 is not a lot of jobs. I suspect 500,000 housing related jobs will be lost in the next recession and that is just housing related. Besides, Bush has announced he wants to "balance the budget". Of course we know without a doubt that is a lie, but I suspect we are going to see a few vetoes coming out of the President and increasing looks at pork barrel spending and a few other things as well.

Prechter Comments

Mish, you sound very much like Robert Pretcher in this article -- that mass social mood drives the markets, and stock market is the barometer of social mood. This is the same thing Robert Pretcher has argued for a decade with Stock Market as the leading indicator of social mood, but he is a loser.

Mish Reply
Prechter may be right about social mood but he was horribly off on both his deflation call and his call on gold. He missed a huge disinflationary boom otherwise known as "Autumn" on the K-Cycle. Thus he was not off by a decade but decades. As for gold, he seems to think it will do poorly in deflation and I disagree.

Housing Comments

It is an indisputable fact that Housing, and Stocks are the 2 most influential assets to mass people. I believe Japan failed to stop deflation because the central banks pump uncontrolled money to both stock and real estate at the SAME TIME; when both collapsed, deflation it was. I believe Greenspan and Bernanke have learned such that, pump one of them and let the other down -- mutually cancel out the negative effects. Possibly, pump one of them to much higher to gain a net positive effect on social mood. This is what happening today.

Mish Reply
Housing and stocks are indeed the two essential asset classes. There is also evidence that foreign central banks are attempting to prop up those assets with their policies simply to keep consumers consuming. But to propose that the key is to prop one up and then the other and that will accomplish something is basically absurd. For starters housing is far more important to most people than stocks are. Close to 70% of the nation owns house (using the word "own" loosely). Many "own" multiple houses. In 2005 close to 35% of all homes sold were second homes or investment homes.

In contrast the amount held by most people in the stock market is small. Furthermore studies have shown that there is a greater propensity to spend increases in home prices than stock prices. Given that most houses are not paid off, there is also a huge liability should prices decline as is happening now. This has the effect of contracting credit. You can see it now in bank willingness to make subprime loans. That is just the start of what is going to happen to housing. Stock prices simply can not in any way shape or form counteract a complete debacle in housing. If defaults get big enough, regardless of what anyone tries to do, credit spread will widen and that will undoubtedly be bad for stocks. It is just a matter of time.

Again I am stunned by the massive faith people seem to have in the Fed and the government to do something intelligent that will keep the bubble expanding in an orderly fashion. I am also stunned by the belief that propping up the markets can possibly work in the long haul. Intervention seldom works and when it does, it is only in the short term, and normally only in the direction of the prevailing trend.

I happen to believe that housing is the bubble of last resort. Housing created jobs, and borrowing against home prices kept people spending. What now? I keep asking but no one has ever been able to tell me what the next biggest bubble that creates jobs and credit to the extent that housing did. The problems here are extreme. In a nutshell: We need a bubble in the US, that creates US jobs (as opposed to jobs in China), with rising wages that allows the servicing of that debt, and a continued expansion of credit by willing and able lenders and borrowers both. How likely is that?

Bernanke Comments

Mish you actually ignore an enormous amount of 1990s monetary theory by Bernanke and co about how they would have dealt with Japans deflation.

Mish Reply
It is Bernanke who fails to understand the great depression even though it was his favorite study. You can listen to a man that proposes dropping money out of helicopters but I prefer to listen to someone like Paul Kasriel or professors John Succo or Scott Reamer on Minyanville. Bernanke does not understand either the cause or the cure of the great depression. That is the simple fact of the matter.

Trucking

Look at the trucking data. Mish, I can't believe you made the same mistake as Walmart. Truck volume is now back to Summer of 2005, pre Katrina/Rita levels. All your chart shows is a hurricane blip during a time of stagnant volume.

Mish reply.
Exactly what chart are you looking at? Trucking is back to the level of September of 2002. Trucking is a good measure of demand for goods.

Treasuries
How can purchasing US government debt instruments be a good investment when almost by definition there will be massive defaults?

Mish Reply
How can government bonds possibly NOT be a good investment? Seriously, is the US going to default on treasuries? It is quite literally next to impossible. The US owes money in its own currency. There is no risk of default. There is a theoretical risk that the US will print money to pay back debts but that is not what was asked (and I have addressed that elsewhere). In deflation government bonds, cash, CDs and most likely gold will be about the only things that do not get hammered senseless. Look at it this way. Cash in deflation increases in value by definition. Treasuries and CDs pay interest but cash does not.

Weimar Republic

What is your assessment for the causes of prior hyperinflations in the US, Wiemar Germany and Zimbabwe or France, per that last reference I posted some time ago?

Mish Reply.
I have answered this question on Weimar several times already. Here goes one more time. There is an enormous difference between current US condition and the Weimar Republic. For starters M2 has only been growing at an average annual rate of 6.9% since 1969. The monetary base is not expanding anywhere near that fast. These amounts have little to do with hyperinflationary conditions. Credit has increased at a far faster rate recently but the other side of credit is debt. When individuals or companies are no longer able to service their debt, bankruptcies and foreclosures happen. If bankruptcies and writeoffs happen faster than credit and money expand, the result is deflation.

In contrast, the Weimar Republic underwent massive printing to pay war reparations required by the Versailles treaty after WWI. France sent their army into the Ruhr region to enforce their demands for reparations, and the Germans were powerless to resist.

So the printing presses ran, and once they began to run, they were hard to stop. The price increases began to be dizzying. Menus in cafes could not be revised quickly enough. A student at Freiburg University ordered a cup of coffee at a cafe. The price on the menu was 5,000 Marks. He had two cups. When the bill came, it was for 14,000 Marks. "If you want to save money," he was told, "and you want two cups of coffee, you should order them both at the same time."

The presses of the Reichsbank could not keep up though they ran through the night. Individual cities and states began to issue their own money.When the 1,000-billion Mark note came out, few bothered to collect the change when they spent it. By November 1923, with one dollar equal to one trillion Marks, the breakdown was complete. The currency had lost meaning.

The key issues here are an expansion of credit in the US vs. a massive expansion of the monetary base in the Weimar Republic, war reparations, and occupation of Germany by France after the war. Is France demanding war reparations from the US and occupying Chicago until it gets them?

Comparing the US to Zimbabwe is even more ridiculous.

Zimbabwe fell into hyperinflation after the government began seizing commercial farms in about 2000. Foreign investors fled, manufacturing ground to a halt, goods and foreign currency needed to buy imports fell into short supply and prices shot up.

Mr. Mugabe's government has printed trillions of new Zimbabwean dollars to keep ministries functioning and to shield the salaries of key supporters — and potential enemies — against further erosion.

In February, the government admitted that it had printed at least $21 trillion in currency — and probably much more, critics say — to buy the American dollars with which the debt was paid.

By March, inflation had touched 914 percent a year, at which rate prices would rise more than tenfold in 12 months. Experts agree that quadruple-digit inflation is now a certainty.

Toilet paper costs $417. No, not per roll. Four hundred seventeen Zimbabwean dollars is the value of a single two-ply sheet. A roll costs $145,750 — in American currency, about 69 cents.

Is the US government about to seize farms or private enterprise of any kind?

The last hyperinflationary period in the US (using the word hyperinflationary loosely) was in the 70's and 80's when gold soared over 800 and oil prices rose dramatically and interest rates hit 18%. That was caused by a massive wage/price spiral of rapidly rising wages and prices.

Conditions today are nearly opposite. I debunked the 70's rerun theory in 1929 Revisited. Today wages are falling on account of outsourcing and global wage arbitrage. Overcapacity is rampant, and ability of consumers to take on additional credit is limited. Debt servicing is a huge issue now.

The US Dollar
The Dollar will collapse causing hyperinflation.

Mish Reply
Collapse against what? People seem only to look at the situation in the eyes of the US dollar. There is massive credit expansion right now in Europe, the UK, China, and emerging markets (and has been for years on end actually). Credit is actually expanding faster in Europe now than the US. The problems in the US are severe but Japan, Europe, and the UK all have their own problems. Japan has a national debt 150% of GDP. The US is not close to that. In addition, people keep forgetting the dollar has already collapsed. What else do you call it when the dollar indeed falls from 120 to 80? Did that collapsing dollar cause either hyperinflation or the price of imported goods to massively rise? I think not. Just look at prices of anything and everything coming from China as proof. What did happen was a bubble in credit lending caused a massive increase in the price of housing and that bubble is now collapsing.

Speculation in anything and everything is still running rampant. Not just in the US but everywhere: equities worldwide, junk bonds, emerging markets, commodities, etc, all with leverage. The unwinding of that leverage is likely to be supportive of both the dollar and treasuries. A reversion towards savings in the US will also be supportive of the US dollar and treasuries. A flight from junk will be supportive of US treasuries.

If and when the Fed starts fighting deflation by lowering interest rates I believe but can not prove that gold will be the beneficiary. But it will not be just a gold rise against the US dollar, but a rise in gold compared to all fiat currencies. The dollar is likely to crack in due time but now does not seem to be the time. Even IF the dollar were to crack now, it is debatable as to what effects that might cause on the prices of goods and services in the US. Besides, a focus on the dollar is secondary to credit and debt servicing issues. Yes the dollar will ultimately collapse right with every other fiat currency and the answer to the question I posed “against what?” is gold.

Able and Willing

Mish, Your question, "Is the Fed willing to cause hyperinflation?", implies that the Fed could cause hyperinflation. If that's true, couldn't they by definition stop deflation by causing enough inflation to offset whatever deflationary forces arise?

There are two issues here and they are different
1) The Fed has to be willing to cause hyperinflation(I doubt they are).
2) Even IF the Fed is willing banks and consumers and businesses have to oblige.

If the Fed initiates a massive printing campaign and banks do not lend (because they are not willing or consumers are not willing to borrow) the velocity of that printed money is zero. In that situation, printing in and of itself simply would not do much of anything. As noted before, the Fed by itself can not create jobs, raise wages, force banks to lend, deposit money into people's accounts, or cause a psychology shift to make people or businesses want to borrow.

The Fed in conjunction with Congress could in theory cause hyperinflation but only to the detriment of banks and themselves and in fact everyone else too. Once again, if deflation was so easy to avoid, the great depression and the Japanese deflation would not have happened.

My Final Thoughts

I am amazed at the near universal belief that everyone seems to have in the Fed and the Government. The arguments proposed and the comments made seem to imply that the Fed can pull off some sort of miracle bailing out consumers by causing wages to rise, property values to rise, the stock market to rise, and to create enough jobs so that everyone can live happily ever after.

That is not exactly a fair statement because some think the Fed will overdo it to the point of causing hyperinflation. Either way, people give the Fed far too much credit and intelligence when history proves otherwise. Yes, the Fed has for what seems like forever been willing to blow bigger bubble after bigger bubble. Here is the key: They were able to do so because banks were willing to lend and consumers were willing to borrow.

It can't go on forever simply because ability to service debt at some point becomes impossible. The pool of real funding (savings) dries up, and financial speculation on its own accord stops being supportive of the real economy. Financial and asset speculations of this magnitude throughout history have never ended well. There were deflationary crashes in Japan, the Great Depression, the South Seas bubble, the John Law Mississippi Bubble, Tulip Mania, etc. In each case the bubble collapsed after sentiment changed towards speculation. Once sentiment changed it was never again revived.

The root cause of the bubbles was a massive expansion of money and credit in conjunction with massive speculation by the public. Given that the cause of those bubbles was that expansion of credit and speculation, it is incredulous to believe that the Fed or the Government can cure the problem by throwing still more money at it. That has never worked before in history and it won't be different this time either.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/

Money Supply and Recessions

This post is an attempt to construct an active chart of money supply data that is useful in assessing the likely direction of future economic activity. This is an ongoing effort that relies heavily on the work of Austrian economist Frank Shostak who has previously written on this subject on the Ludwig von Mises Institute and other places.

Before we can construct charts of money supply we first must agree what it is we want to measure. Answers.com provides many definitions definition of money but none of them are useful for our purposes. Wikipedia's disscussion of Money Supply includes M0, M1, M2, and M3. There is also MZM (Money with Zero Maturity). So which one of those makes the most sense to track?

Please stick around because the answer might surprise you, with lots of neat charts to prove it (click on any chart for a better look at it) . But first let's tackle the methodology.

In The Mystery of the Money Supply Definition Shostak wrote:

The crux in identifying what must be included in the money supply definition is to adhere to the distinction between a claim transaction and a credit transaction.

According to popular thinking, the inclusion of savings deposits into the money supply definition is justified on the grounds that money deposited in saving accounts can always be withdrawn on demand. But the same logic should also be applied to money placed with an MMMF [Money Market Mutual Fund]. The nub, however, is that savings deposits do not confer an unlimited claim. The bank could always insist on a waiting period of thirty days during which the deposited money could not be withdrawn.

Savings deposits should therefore be considered credit transactions with depositors relinquishing ownership for at least thirty days. This fact is not altered just because the depositor could withdraw his money on demand. When the bank accommodates this demand, it sells other assets for cash. Buyers of assets part with their cash, which in turn is transferred to the holder of the savings deposit. The same logic is applicable to fixed-term deposits like CDs, which are credit transactions.

Though traveler’s checks are considered an integral part of the money supply, they should not be. Traveler’s checks are receipts for investment in the companies that issue them. As such, they result from a credit transaction, and therefore are not part of the money definition. Cashing a traveler’s check means that AMEX or VISA will transfer money from their deposits to the holder of the check, which will not change the amount of money in the economy.

Mainstream thinking currently excludes from the money supply government deposits held in banks and the central bank. Consequently, if the government taxes people by one billion dollars, money is transferred from their deposits to the government’s deposit. This is viewed just as if the money supply fell by one billion dollars. In reality, however, the money is now available for government expenditure, meaning that money held in government deposits should be part of the definition of money.

Incorporating all the above arguments, the money supply is defined as follows: Cash + demand deposits with commercial banks and thrift institutions + government deposits with banks and the central bank.

This definition shows clearly that any expansion in money supply results solely from central bank injections of cash and commercial banks’ fractional reserve banking.

In Making Sense of Money Supply Data Shostak further explains the flaws of M2, M3, and MZM as monetary measures:

Consider M2. This definition includes money-market deposit accounts. However, investing in a money market fund is in fact investment in various money market instruments. The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed.

If Joe invests $1,000 with a money market fund, the overall amount of money in the economy will not change as a result of this transaction. Money will move from Joe's demand deposit account to a money market demand deposit account with a bank. To incorporate the $1,000 invested with the money market fund into the definition of money plus the original $1,000 would therefore amount to double counting.

The problem of double counting is also not resolved by the money of zero maturity definition of money (MZM)—a relatively recent money supply definition. The essence of MZM is that it encompasses financial assets with zero maturity. Assets included in MZM are redeemable at par on demand. In short, MZM includes all types of financial instruments that can be easily converted into money without penalty or risk of capital loss. This is precisely what is wrong with this definition, since it doesn't identify money but rather various assets that can be easily converted into money. In short, it doesn't tell us what money actually is and where money is located, which is what a definition of money is supposed to do.

From the above we can see that M2 double counts some aspects of money and since M3 incorporates M2, it is equally flawed right off the bat. M2 also counts savings accounts which are really credit transactions and MZM is hopelessly flawed as a money definition because it attempts to count things that can easily be converted to money as opposed to money itself.

M1 is flawed by the inclusion of travelers checks and the exclusion of demand deposits with commercial banks and thrift institutions + government deposits with banks and the central bank. M1 also has another huge problem and that problem is sweeps.

Returning to The Mystery of the Money Supply Definition we see:

Since January 1994, banks and other depository financial institutions have initiated sweep programs to lower statutory reserve requirements on demand deposits. In a sweep program, banks “sweep” funds from demand deposits into money market deposit accounts (MMDA), personal savings deposits under the Federal Reserve’s Regulation D, that have a zero statutory reserve requirement ratio. By means of a sweep, banks reduce the required reserves they hold against demand deposits.

Essentially banks are taking money that should be available immediately on demand (and expected to be demanded sooner rather than later by the very nature of checking accounts) and loaning it out anyway. That money is missing from M1 published demand deposits numbers. Unfortunately sweeps data only comes out once a month (at least from the free sources at my disposal) but once a month is probably often enough for most purposes.

The definition I am now working with is Cash + demand deposits with commercial banks and thrift institutions + government deposits with banks and the central bank + sweeps + other checkable deposits. I added other checkable deposits because with their inclusion I could better match previous publicly posted Money AMS charts by Shostak.

I received charting help from a couple of people that I now need to thank (originally "Yaniv" followed by "Bart" at NowAndFutures). Since we are not sure if this exactly follows MoneyAMS (in fact we are sure that we are slightly off MoneyAMS from 2003 on), we are calling our indicator M' and pronouncing it M Prime.

Let's see how M' does compared to M2 as a predictor of economic activity.

M Prime



Leaving the current status as unknown, 6 of the last 6 recessions were marked by a major dip in M Prime. Note how the indicator clearly led the recession. Also note that 6 of 8 sustained dips below an annual growth rate of 5% in M' led to a recession. On that basis we have 2 potential false signals (1985 and 1995).

M2



Unlike M', the direction of M2 does not seem to give clear economic signals. Note that M2 was rising into the double dip recession of 1982 and rising into the 1991 recession as well. Also note that the single largest dip in M2 was in 1993 while M' was soaring. The years between 1992 and 1995 are all problematic. Finally note that unlike M' where a dip below 5% annual growth was a huge warning sign, the dotted line above shows no such significance. M' seems to be far superior to M2 as a leading indicator.

M Prime CPI Adjusted



On a CPI adjusted basis we see that there has been a recession on 6 of 7 sustained dips below the zero line of year over year growth in M'. The 1985 excursion below 0% was extremely brief in stark contrast to all of the labeled recessions and thus can be discounted. 1995 is still a miss but nowhere near as pronounced as compared to M' unadjusted. 1995 also happens to correspond to the start of a huge ramp-up in sweeps. Perhaps that is significant and perhaps not. Nonetheless, M' CPI adjusted gives a cleaner signal, arguably calling for 7 recessions of which 6 happened.

The above chart clearly shows M' CPI adjusted to be a strong leading economic indicator.

M2 CPI Adjusted



M2 CPI adjusted is certainly an improvement over M2 CPI unadjusted. Note however, that the 1982 and 2001 signals are not as strong as the corresponding M' CPI adjusted signals. The M2 adjusted signal for 2001 was particularly weak. More problematic for M2 adjusted vs. M' adjusted is the mass of jello between 1988 and 1996. M' adjusted was clearly giving an "all clear" zero cross signal by 1992 while M2 adjusted gyrated for years and did not really give an "all clear" until 1998. Furthermore M2 adjusted actually dipped back below the zero line in 1997 while M' adjusted was soaring upward. Both M2 and M' missed around the 1996 timeframe but even here M2 did worse both in terms of an actual low and the jello that preceded it.

Since everyone seems to be focused on M3 here are the two corresponding M3 charts for the above series.

M3



M3 CPI Adjusted



As leading economic indicators, the above charts on M3 fared worse than M2 and far worse than M Prime. M3 CPI adjusted failed as a leading indicator in 3 out of 6 recession but did act as a lagging indicator in the 1973 to 1975 recession. Perhaps this lends credence to the Fed's statement that they see little use for M3. Still it is easy enough to post the figures since they have the data.

One thing you can say about M3 is that it that for all this credit expansion, we sure do not have a lot of GDP growth to show for it. The real economy is not benefiting.

The CPI Adjustments

One of the problems in constructing the CPI adjusted charts is believing the CPI number itself. Clearly there is a lot of disagreement with the CPI numbers. Yet without the adjustment, using M2 as any kind of leading indicator is nearly useless. In contrast, M' is a very good leading indicator in and of itself, but it seems to be a better one when adjusted. Yaniv, Bart, and I tried various combinations of including or excluding other monetary figures but none of them performed as well as what Shostak proposed as theoretically ideal.

In one test we tried using alternative estimates of CPI based on John Williams' Shadow Statistics. Those tests seemed to make some things worse and some things better. Here are a couple Shadow Statistics charts to consider.

Shadow Statistics





The first chart shows an approximate average of the Official CPI and the Shadow to be running at approximately 5%. The second chart shows an approximate 5% trendline using Pre-Clinton measures of CPI. (The dashed trendlines were added by me). Meanwhile the long term annual rate of change on M' and M2 since 1969 are 6.5% and 6.9% respectively. All of this calls into question what the Fed is really doing.

Regardless of what the Fed is or is not doing (purposely or otherwise), it is impossible for them to succeed with price targeting. This idea was discussed in Is the Inflation Monster Tamed? when the following questions were asked:

• Why should inflation be targeted at 2% and not 1% or 3%?
• Why should any inflation be targeted at all?
• Even if it was for some reason smart to target prices, can prices really be measured it accurately?
• What do central banks do to overcome lag effects of monetary tightening and loosening?
• Is this just blind faith "we know neutral when we see it"?

Who benefits from inflation?

Inflation benefits those that receive money first: the government and banks. The former is via automatic tax increases not indexed to inflation (especially property taxes), the latter simply because banks are first in line to receive money from the FED at rates no one else sees. By the time lending standards drop so that the masses have access to credit, the boom is well underway. By the time credit is granted to anyone that can fog a mirror, the boom is nearly over. Those buying assets late in the game will eventually be crushed by those selling assets that got in early. Simply put, inflation eventually becomes a moral hazard.

Proof that the Fed is not succeeding can be found in the endless series of bubbles that keep getting larger and larger, as well as the ponzi like scheme it is taking to keep things afloat.

As for leading indicators, the charts speak for themselves. Given that our starting point is the best Austrian approximation of money under the current fiat system that we could find, it should not be surprising that those monetary indicators give off far superior leading economic signals than other methods.

I wish to thank Frank Shostak for his enormous contribution to these efforts. I also wish to thank "Yaniv" who started this charting exercise with me a year ago or so, "Bart" who picked up when Yaniv ran out of time, John Williams at Shadow statistics, Scott Reamer on Minyanville, Paul Kasriel who offered some comments that I will share later in a post on leading indicators, and anyone and everyone that contributed to this effort.

Mike Shedlock / Mish
http://globaleconomicanalysis.blogspot.com/