Spiking US money supply doesn’t cause or drive deflation

Genevieve Signoret

Anthony Doyle (Bond Vigilantes) has published a neat graph showing that money supply in the USA is accelerating sharply:

Looking at US M2 money supply, an increase of 10.1% over the year to September 2011 should be a cause for concern. A higher rate of money supply growth has occurred on only five occasions since 1984 (including last month). The Fed thinks this is because institutional investors, concerned about exposures of money funds to European financial institutions, shifted from prime money funds to bank deposits, and money fund managers accumulated sizable bank deposits in anticipation of potentially large redemptions by investors. In addition, retail investors evidently placed redemptions from equity and bond mutual funds into bank deposits and retail money market funds.

Doyle then reviews theories as to the meaning:

Some economists believe excess growth in money supply suggests asset price inflation and consumer price inflation. Others believe the increase is deflationary in the short-term as it likely reflects a flight to safety and low expected asset returns. I have some sympathy for this view as the last time year-over-year growth in demand deposits was at current levels the US economy was in a deep recession.

I’m in the camp that sees exploding money supply as driven by flight to safety. But I think it’s inaccurate to call the spike “deflationary”. The term suggests causality: the notion that accelerating money supply might cause deflation. Not so. It’s a consequence of the aversion to euro bank credit risk driving refusal to roll over short-term funding to euro area banks that are in turn destabilizing the euro area banking system.

This aversion and this refusal are deflationary. Their effect on money supply a spillover.