Monetary Base Breaks Out

Data released by the Fed today confirmed that the Monetary Base has officially risen above the range that it had settled in since July of 2011.  Since roughly the same time period brent crude oil and gold have also been stuck in a prolonged sideways move, although in recent weeks crude has also begun to turn higher along with the base.

Monetary Base So. Close. To Breaking. Out...

The weekly update of the monetary base shows that QE is finally starting to show up on the Fed's balance sheet.  The base is very close to breaking out to a new high three full months into QE3.  As a reminder, one of the reasons we pay such close attention to the monetary base is that it's been highly correlated to oil and gold prices since QE began in 2009.

Monetary Base Ticks Slightly Higher

The monetary base ticked higher by a non-negligible amount for the first time since QE3 started last week.  The Fed has agreed to purchase more than $150B worth of securities since September but up until now the monetary base has remained relatively flat due to the time it takes for mortgage trades to clear and shifts in other balance sheet items which absorbed some of the growth.  

Interestingly the debt ceiling is a driver of this week's growth as one of the "cookie jars" that is keeping the government running is Treasury's deposit account at the Fed.  When Treasury draws this account down to fund itself the money it spends finds its way into the calculation of the base.

It seems like this should be a turning point for the base, but admittedly it's been difficult to predict the way that the dynamics have played off of each other to keep the Base flat.  Tune in next week for an update on whether paint has dried further.

Why the Monetary Base Matters

Below is a comparison of the monetary base and CPI since 1918.  Each series has been indexed so that the value is 100 starting in 1918.  The data is also presented in logarithmic scale so that it's easier to interpret rate of change.  I'll admit there's not a lot of science involved in this analysis, but eyeballing the chart it's fairly clear that inflation and monetary base growth are highly correlated.  Although the series diverge in the late depression/WWII era, they generally exhibit a similar pattern with a slightly lagged increase in CPI following an increase in the base.

If the two series are re-indexed to 100 in 1945, the relationship is even more clear.  Between 1945 and 1983 CPI increases at almost the exact same pace as the monetary base.  In January 1983, when the two series diverge, the CPI calculation was adjusted to substitute a survey of "owner's equivalent rent" for housing prices.  Further adjustments were made under the Clinton administration which slow the pace of CPI growth.

Since 2008 we are seeing another divergence in the relationship between CPI and the monetary base, but as I've noted in other posts, the relationship of the monetary base to oil and gold remains extremely strong, which is consistent with the idea that when more money is printed it becomes less valuable.  It is likely that a commensurate increase in CPI will occur at some point.

Annual Change in Monetary Base Since 1918

After yesterday's post forecasting that we could see a 40% y/y increase in the monetary base in 2013, I thought it might be good to look at a long term chart of the monetary base to put that number into context.  Below is a chart showing the rolling y/y increase in the monetary base since 1918.  The only other time there has been such a steep increase in the US base was during the depression/WWII era during which there were three different periods of 20% annual growth in the base.

Forecast of Monetary Base Through 2014

Well, it's official.  As was widely expected, the Fed announced today that it would increase the size of QE to $85B per month from $40B per month.  Below is an updated forecast of what the US monetary base could look like to start 2015 if QE lasts that long (for the record, my money says it wont).  At its peak growth rate, the base will increase by ~40% y/y.  Under the previously announced program the base was slated to grow by a robust 17%.  By 2015 the monetary base could be nearly 6x the size it was in 2008.

Bank Reserves at Federal Reserve

Over the last several years, many analysts have argued that QE isn't inflationary because the money that the Fed has printed has been locked up in reserve balances.  I don't personally share this view, but it's worth noting that recently reserve balances have been contracting and currency in circulation has been growing as banks have chosen to convert reserves to currency.  Currency in circulation is now growing at nearly a 10% annual rate.

QE3 Just Starting to Hit Fed Balance Sheet

Although QE3 was announced almost 2.5 months ago, the mortgages that the Fed has been purchasing have only just started to hit the Fed's balance sheet over the last couple of weeks.  The monetary base has continued to hold flat, but mortgage holdings have ticked ever so slightly higher.

The Fed has agreed to purchase ~$100B worth of mortgages since September, but holdings have only increased by $40B due to the lag in time of settlement for MBS trades.  The fact that the balance sheet has mostly been unchanged suggests that we may not yet have seen the effects of QE3 in securities markets.

Monetary Base Still Not Growing

Even though QE3 has now been in effect for over a month, the monetary base hasn't budged since it was announced.  As I've documented before, the monetary base has been highly correlated with commodity prices since QE began in 2008, so the fact that the base has not broken out higher could help to explain why crude and gold are also failing to make new highs.

Monetary Base Since QE3

The monetary base is an indicator which I always pay close attention to because it has been highly correlated with the price of oil and gold since 2009.  Since QE3 was announced I have been paying even closer attention to the measure than usual, but it hasn't yet moved as one would expect it to.  Over the last several weeks the monetary base has fallen as the Fed has purchased more MBS for reasons that  I don't totally understand (likely some technicality and timing of the way assets are accounted for in the Fed's H.4.1 release).  I would expect this to reverse in the coming weeks, but until it does, it may help to explain why oil has been weak since QE3 as well.

Comparison of Japan and US Monetary Base

Before the Fed eased last week, I wrote that the ECB's actions could force the Fed to ease in order to maintain the value of the dollar relative to the euro.  Today, the BOJ's decision to purchase another 10T Yen worth of assets confirms that global central banks are in a prisoner's dilemma race to the currency bottom.

Below is a chart of the relative size of the Japanese monetary base compared to the US base.  The Japanese monetary base is about 50x larger than the US base (measured in nominal local currency units), but for most of the last 2 decades it has been more like 100x the size.  The chart implies that as the US monetary base grows compared to the Japanese, the Yen could strengthen further, which is a problem for a Japanese economy that relies on exports.  Unfortunately for Japanese exporters, the Fed has announced an easing program which is likely to be larger than the BOJ's.

Forecast of Monetary Base to 2015 Based on Today's Fed Action

Pretty much as expected, the Fed announced that it will be conducting outright QE at the pace of $40B per month without any clear end date.  Based on this pace of purchases, below is a forecast of what the monetary base could look like out to 2015 assuming that the Fed prints at today's pace for as long as it intends to keep rates exceptionally low.

If this pace were maintained until then, the monetary base would increase by about 5x between 2008-2016, which would be a CAGR of 22%.  The current pace of $40B per month represents an annualized growth of about 18% from current levels.  Given gold and oil's correlation with the growth of the monetary base, $2700 gold and $170 brent crude prices might not be out of the question if the Fed maintains QE for that long.