Now it was not a great quarter, but considering the banking failures and interest rate hikes, equities were remarkably resilient.  The gain of 7% or so in the broad market average was welcome.  The tech-laden NASDAQ was up 17%.  Recall the broad average was down 19% last year.

Gold was up about 9% and bonds as measured by the I shares Bond Aggregate were up about 3 1/2%.

Readers might remember that stocks broke upward out of a bear trend, then failed and dropped back below the trend, only to once again scramble back above major moving averages and trendlines.  Whew!

On March 22, the CNN Fear and Greed gauge hit a low of 22, an extremely oversold reading for sentiment.  As we write, it has rebounded back to 50, which is a neutral reading.  The low for the quarter in terms of price came on March 13, followed by a sharp rebound. But the swing in sentiment shows just how rapidly minds are changing in just a two-week period.

Apparently, Mr. Market figures the FED will not be raising rates anymore because the FED will not want to risk aggravating the banking crisis further.  Traders seem anxious to get back to the days of cheap money.  It is all they have known for almost 20 years so you can’t blame them.

Surely the banking problems will force the FED to pivot.  However, with inflation persisting, the FED either gives up on inflation or risks further banking difficulties.  Choosing inflation is not necessarily going to be great for the market, although we admit, that seems to be the working assumption right now.

In fact, the behavior of the market is very similar to what gave us the recent top.  During the recent rebound, once again a handful of high-capitalization tech stocks (much like the FANG stocks of previous fame) are creating the bulk of the gains for the index.  In fact, the equal-weight S&P, which removes the distortion of the FANG stocks, was up only half of the amount of the regular index.

Jesse Felder, an astute market analyst points out that the combination of Apple, Nvidia, Microsoft, Meta, Tesla, Amazon, Alphabet, Salesforce, and AMD have contributed ~160% of the S&P gains so far this year.

Without just this handful of companies, the averages would be negative.

Generally speaking, a healthy market shows broad participation in price improvement. Narrow price strength, particularly in such small numbers of huge companies, is not healthy.  So, while the percentage recovery shows a decent quarter, the way we are getting it is unhealthy. Bulls better hope the price strength spreads soon to many more companies.

Moreover, those companies creating most of the gain are extremely expensive in terms of their market metrics.  It would be unusual, to say the least, for companies that are already extremely expensive, to be able the lead the market higher on a sustained basis.

The banking crisis seems to have come and gone rather quickly, too quickly we think.  Deposit outflows from banks continue, which suggests the problem is not over.  Not only do continued withdrawals risk ensnaring marginal banks in liquidity problems, but deposit outflows will also cause banks to be more reticent to lend except to the most credit-worthy borrowers.  That will tend to deny access to credit by the marginal borrower.  Couple that with higher interest rates already in place, and it would seem this will be a factor to slow the economy.  Some people will not be getting credit when they want and need it and many have substantial debts to roll over.

In addition, OPEC suddenly and surprisingly announced production cuts, which will add to the price of energy, which will most likely add to the inflation problem, which will make it difficult for the FED not to follow through with more rate hikes.

Japan has said they will be buying Russian oil, weakening the Western Alliance insofar as their using sanctions to bring Russia to heel.

The political front has not improved much either.  Worries about the debt ceiling crisis have also faded fast as well but the problem remains unresolved.  Speaker Kevin McCarthy says the GOP seeks concession but the White House for two months has refused to even talk to House Republicans.  In fact, this problem is still very much in play and the White House has gone beyond brinksmanship into what appears to be a political coma.  Democrats seem extremely confident that Republicans won’t be able to stick together.

If Republicans can stick together and propose common sense cuts, such as a return of government spending to pre-Covid levels, they could put the Democrats in the position of threatening default on the debt of the US.

Meanwhile, another warning was issued suggesting that Social Security will run out of money in just a decade.

A number of countries and taking preliminary action to dethrone the US dollar as the reserve currency and oil payment currency of the world.  This seems like an arcane subject to many but it is fraught with serious implications.

Right now, our government, and only our government, can print money to satisfy foreign debtors and pay for oil.  No one else can do that.  It is doubtful the average voter understands how serious it will be for our standard of living if the dollar is knocked from its pedestal.

In summary, the gains are welcome but are on shaky grounds. Most of the problems plaguing the market remain unresolved.

The collapse of Swiss banking giant Credit Suisse recently was a catastrophe long in the making. A quick perusal of the bank’s financial statements from recent years shows that we’re dealing with something analogous to a classic bank run. Credit Suisse’s pool of liquid assets declined more than 50 percent from 2021 to 2022, mostly in October 2022, from CHF 229.9 billion to CHF 118.5 billion as depositors withdrew their money. Despite the timing, however, the fall of Credit Suisse had little directly to do with the collapse of Silicon Valley Bank and a lot to do with the contraction of the international monetary system.

The Contractionary Fed

As pointed out last year, the Federal Reserve has long pursued a deflationary policy. This may come as a surprise, since official inflation numbers are still elevated and Federal Reserve officials have continued (until very recently, at least) to pronounce their determination to bring down inflation. However, if we look at changes in the money supply, and especially changes in that part of it the Fed directly controls, it becomes apparent that sizeable deflation has been occurring. The US M2 money supply had been slightly falling since April 2022 and in total declined by about USD 900 billion until February 2023 (figure 1), but the real contraction is significantly larger.

To see this, we only need to look at the Fed’s balance sheet, specifically at reverse repurchase (repo) agreements (which is where the Fed sells an asset and promises to buy it back the following day at a slightly higher price determined by the repo rate). As I pointed out last year, by accumulating reverse repos, the Fed is effectively sterilizing bank reserves. Banks and financial institutions move their cash into repos at the Fed, where they earn a cool, risk-free 4.80 percent. As a result, the reserves in the financial system have fallen, since repos do not serve as reserve balances for the commercial banking system. Reverse repo operations have partly served to soak up reserves added to the system during the corona inflation, but it is important to note which financial institutions have access to the Fed’s reverse repo operations.

Not all banks have access—in addition to the primary dealers, only accepted reverse repo counterparties can conduct business with the New York Fed. A quick look at these lists reveals them to be a veritable who’s who of Wall Street and international investment banks, from old names like J.P. Morgan and Goldman Sachs to more recently famous Blackrock and Vanguard to Swiss banks Credit Suisse and UBS. It is especially the international aspect that is of interest here. It is the markets that these international banks operate in that have been drained of dollars due to Fed deflation—and above all, that means the Eurodollar system.

Eurodollars and the Fed

Eurodollars are simply dollar deposits originating outside the United States and thus not subject to US regulations. Since the 1960s they have played an increasing role in the international financial system. The Eurodollar system is not, however, totally detached from the American banking system; above all, it is not detached from the Federal Reserve. The Eurodollar banks, like all modern banks, operate on a fractional reserve basis.

Thus, if reserves are cheap and plentiful, they expand; and if reserves become expensive and scarce, they contract. The ultimate supplier of reserves is the Federal Reserve—either directly, through related international investment banks or indirectly, through US banks that supply credit to international borrowers. Thus, while the expansion of Fed reverse repos seems to have had only a belated and weak effect on the domestic money supply, the Eurodollar institutions experienced a significant contraction of reserves.

Unfortunately, we have no direct knowledge of the number of Eurodollars in existence, but the rapid appreciation of the dollar throughout 2021 and 2022 suggests that there was a substantial contraction of the Eurodollar supply (figure 2). This contraction also compares well with changes in reverse repos: the dollar appreciated continuously to almost 96 cents per euro in late September 2022, only to depreciate rapidly thereafter, while reverse repos reached a peak of USD 2.4 trillion on Friday, September 30, 2022, and have fallen significantly since (figure 3; it should be noted that there is a seasonal spike in reverse repos at quarter end, but the trend is clear). The Fed’s contraction therefore really ended back in October 2022—after that, no talk of tightening was connected to the reality in the international dollar market.

Back to Bern

It is surely significant that the change in Fed policy came about at exactly the time that Credit Suisse felt the squeeze, in October 2022. Now, this change in policy was not necessarily entirely driven by the Fed, since credit contraction would drive up interest rates in the market and thereby make it attractive to move from reverse repurchases to expansionary private lending anyway. As credit tightened for Credit Suisse, the Swiss bankers would be willing to pay dearly for short-term loans to fund the outflow of deposits and avoid illiquidity and bankruptcy. However, that can only explain a short-run change in the flow of liquidity. The turn to loose money in October, then, was a deliberate policy change, aimed at propping up the Eurodollar market.

One can speculate about what prompted the Feds to first drain the Eurodollar system and then reverse the decision when the first bank threatened to collapse. It is always a live option that these people did not, in fact, know what they were doing—but it strains credulity that the Cantillionaires, those bankers and financiers close to the central bank, whose wealth and power depend on access to the Fed and the privileges supporting the broader fiat money system, did not realize the implications of the policy changes.

According to the central bank’s own explainer, raising the repo rate (and thus attracting more reverse repos) is simply a necessary part of raising the interest rate on domestic reserves and thereby preventing a domestic overexpansion of the money supply. Since the Fed risked losing all credibility if it did nothing in the face of the high inflation and monetary overhang from the corona policies, Chairman Jerome Powell and his fellow rate setters may simply have felt forced. Once their primary clients, the Cantillionaires, really felt the heat, however, the Fed quickly changed gears.

Central Bank to the World?

In the aftermath of the collapse of Credit Suisse, still in the process of being taken over by UBS, on March 19 the Federal Reserve and the main central banks of the Western world reactivated their liquidity swap lines. These swaps lines were a key tool in “saving” the international system after the great financial crisis and will play a similar role today: non-US central banks will borrow dollars from the Fed using their own currencies as collateral.

Say the Swiss National Bank (SNB) wants to supply Swiss banks with dollar liquidity. In a swap with the Fed, it first buys a dollar deposit at the Fed in exchange for a Swiss franc–denominated deposit at the SNB. The SNB can then use the dollars to supply liquidity to the Swiss financial system. To close the swap, the SNB sells the dollar deposit back to the Federal Reserve against the Swiss franc deposit. The exchange rate in this transaction is frozen; the Swiss National Bank only has to pay a small amount of interest on the loan. However, the swap is also an inflationary instrument: money is newly created to be used in these swaps—after all, that’s all a central bank can do.

A second important inflationary policy that the Fed has reactivated is the Foreign and International Monetary Authorities (FIMA) Repo Facility. Here central banks can borrow from the Fed using US Treasurys as collateral. While the focus in the press has been on the liquidity swap lines, the real action so far has been here: the supply of repos to foreign official institutions has expanded from zero to USD 60 billion in the week ended Wednesday, March 22. This looks so far to be a limited, one-off liquidity support—the coming weeks will show how many dollars the Fed will inject into the global dollar system.

It may sound like the Federal Reserve is now engaged in an altruistic quest to save the global financial system, and that is the stated intention. But it is far from altruistic. The Eurodollar system and the rest of the central bank–sponsored global financial system benefit the Fed’s real patrons among the Cantillionaires, who are placed in a position of privilege as bankers to the world. If the Eurodollar system collapsed, the Fed would have the most to lose. After all, any currency could serve as the global trade currency; the global use of the dollar and the Eurodollar system supported by the Fed and Western central banks are not necessary. However, he seigniorage the US earns on the global use of the dollar funds the US’s permanent balance-of-payments deficit: dollars and debt are exported in exchange for real goods and services, while Americans buy up foreign assets at a discount. Barry Eichengreen estimated that the US pays 2–3 percentage points less on its foreign liabilities than it earns on its foreign investments.

In fact, the global financial system resembles the old Bretton Woods system. Bretton Woods led to a great wealth transfer from Europe to the US—to the spoliation of Europe, as Jacques Rueff called it. The modern, dollar-based financial system leads to similar benefits for the US economy and for US-based financiers. Americans can consume more and the US government can spend more because foreigners are forced or induced to use the US dollar. The Federal Reserve, now and always, is simply acting in the narrow interests of its sponsors. These interests dictate policy. Fed tightening was probably seen as necessary to maintain the legitimacy of the system, but once serious problems emerged back in October, the Fed quickly changed gears to easing. That Credit Suisse fell despite this change, and that we now see much more drastic interventions in the financial system, only shows the limitations of central bank power. Inflation can only distort reality for a while, benefiting some and hurting others, it cannot permanently lead to general prosperity—a crisis must come.

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This article was published by Mises Institute and is reproduced with permission.

There is perhaps no empirical regularity among economic phenomena that is based on so much evidence, for so wide a range of circumstances,” Milton Friedman observed in 1989, “as the connection between substantial changes in the quantity of money and in the level of prices.” And yet, despite the wide body of work alluded to by Friedman, most monetary policymakers and economists believe that there is no information to be gained by looking at monetary aggregates. This widespread belief has resulted in governments’ not estimating monetary aggregates, or else estimating them for a much narrower set of series than in prior years. Monetary aggregates make no appearance in many econometric models of the economy, and are rarely if ever brought up in the briefings for Federal Open Market Committee meetings.

This widespread belief that monetary aggregates are uninformative is incorrect.
Figure 1. Excess Money Growth and Inflation in 108 countries, 2008-2022.

Figure 1 shows the excess growth rate of money measured by M2 and the inflation rate across 108 countries for 2008 to 2022. M2 is a monetary aggregate that estimates the funds available to buy goods and services. It includes currency, checking accounts, and savings accounts that are close substitutes for currency and checking accounts. The excess growth rate of money is the growth rate of M2, less the growth rate of real income, as measured by GDP. The growth rate of income subtracts the non-inflationary growth of the goods and services available. If the growth rate of money and the growth rate of income were equal, then the inflation rate would be roughly zero. Growth of money in excess of income growth fuels inflation.

The positive relationship between the inflation rate and excess money growth over these 14 years is obvious. A linear relationship with a coefficient of one between inflation and excess money growth is an implication of some theories relating inflation and excess money growth. The correlation of inflation and excess money growth is 0.92. The slope of a line relating inflation and excess money growth is 0.95, when estimated by a regression of inflation on excess money growth.

While not one, 0.95 is not all that far from one. Figure 1 shows a line with the one-for-one relationship and another with the slope of 0.95. They are not all that far apart. Most of the countries in Figure 1 have lower inflation than implied by the excess money growth. This means that the demand for money in these countries increased even more than is implied by the growth rate of real income alone. It does not mean there is no relationship between money growth and inflation.
Figure 2. Excess Money Growth and Inflation in Countries with less than 30 Percent Inflation, 2008-2022.

An often remarked aspect of Figure 1 is that the correlation may just reflect the high-inflation countries and the relationship for the low-inflation countries is far less evident. Figure 2 shows the relationship between excess money growth and inflation for countries with average inflation less than 30 percentage points per year. The relation is not as clear, but the correlation between excess money growth and inflation is 0.75. While this correlation of 0.75 is less than a correlation of 0.92 for all the countries, it is hardly trivial.

The slope of the regression line has a larger difference. Comparing the two figures, it is clear that the regression line in Figure 2 deviates from the slope equal to one by more. The slope of the line is 0.85, which is farther from one than 0.95 but also far from zero. And zero is the number implied by an assertion that the information content of monetary aggregates is zero.

The data in Figure 2 are averaged over fourteen years of growth. The fourteen years is the result of data availability. But while the relationship between excess money growth and inflation is evident over longer periods of time, it is not particularly evident for short periods of time. For the data in Figure 1, the correlation of the annual growth rates of excess money and inflation is 0.69, quite a bit less than the 0.95 with the fourteen years of averaged data. For the countries with lower inflation in Figure 2, the correlation is 0.23, again quite a bit lower than the 0.85 with averaged data.

These correlations show two things:

The relationship is weaker for countries with lower inflation than higher inflation; and
The relationship is weaker over shorter time periods.

There is a common explanation for both of these observations. Over shorter periods of time and in countries with relatively low inflation, Mark Fisher and Gerald Dwyer have shown that inflation which is more persistent than money growth can explain both. Inflation is quite persistent as a general rule and money growth less so.

Is the information content of money growth zero? Unequivocally, the answer is no.

Why does this matter?

M2 in 2020 and 2021 increased by the largest percentages in the last 60 years. To the surprise of the Federal Reserve (although not everyone), inflation resulted. Not all countries have increased the money stock to the same extent. Japan and Switzerland have not had outsized increases in the money stock and have not had higher inflation. Monetary policymakers and economists in the United States and some other countries would have done better if they had not ignored money growth.

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This article was published by American Institute for Economic Research and is reproduced with permission.