Where Money Flows Like Water

Chinese M2 money supply growth accelerated to 16.9% year-over-year in December.

This is the most recent headline contributing to a big worry amidst the investing community: the world is currently "awash" in excess liquidity.

The story goes something like this: because central banks have kept interest rates globally too low for too long, a tsunami of new cash is flooding capital markets. Eventually, all this extra cash will drown the global economy, causing everything from rampant inflation to asset price bubbles in housing, stocks, and bonds.

We think this is poppycock.

The very premise that too much liquidity exists in the world is questionable because it's very difficult to measure monetary aggregates across different countries in the first place. Definitions of money supply and how it is measured vary greatly between nations and almost no two are alike. Financial innovation over the last decade has created various new forms of money that are not reflected in these traditional measures. Even with these imprecise measurements, however, it's clear that money growth has slowed significantly. Global M2 growth numbers, though they have indeed risen in the last six months, are still well off their growth rates of a few years ago. Shouldn't this be obvious? Central banks have been tightening for well over a year now.

The next objection, inevitably, is "Yes, central banks are tightening, but they're still too loose and have been for awhile. The appropriate short term interest rate level is far higher than where it is today."

Really? Why, because your fancy economist model says so? That's the weirdest thing, because reality looks pretty darn good to us at the moment.

Central banks kept rates low as the global economy went through a mild slowdown (it never actually hit a recession) in 2000 through 2003, and then began tightening as the economy recovered fully. Now, as growth has slowed a bit lately, rates as they stand today seem appropriate: money is ample but inflation isn't a threat. Asset markets are doing very well and economies around the world look downright stable. How exactly are we in a bad situation right now? We just don't see it.

The Fed has stopped raising interest rates for now, and benign inflation reports in Europe will likely keep the ECB from raising short interest rates much more—but the bias is to continue tightening. Small moves in short rates don't change the big picture for stocks or the global economy. Central banks can only alter short term rates; long term interest rates are market-determined. While federal banks have raised short term rates recently, market-determined long rates have held steady and should remain so. Absent a major surprise in the interest rate environment, availability of capital for new investment should be plentiful.

However, large policy mistakes by central banks are always a risk—it's one of the pitfalls of not allowing short term rates to be market determined. At the moment, we don't believe central banks have made any grave errors and view current monetary policy as appropriate.

Money supply is only part of the picture—the velocity of money is just as important to account for in measuring liquidity. Velocity is simply the rate at which money is exchanged, or the number of times a dollar changes hands over a given time period. There is no reliable statistical method to directly measure velocity today. Also, a high rate of velocity means high economic activity, since more money is being transacted and more goods and services are being delivered. (That's a good thing.)

So, liquidity is in good shape. What about inflation?

For starters, the US core PPI inflation rate for December is forecast to be a lowly 0.2%, and let's not forget oil's precipitous decline so far this year.

Also, standard market indicators continue to signal benign inflation expectations. If inflation were truly a threat looking into the near to medium term, it would show up in global long term interest rates. Today, long rates point toward a benign inflation outlook. Other inflation sensitive indicators such as Treasury Inflation Protected Security (TIPS) spreads are also not sounding alarm bells at present.