Nomura | JPNRichard Koo May 17, 2011
When a central bank provides liquidity to the market, it buys government debt or other securities in exchange for cash. Theprevious owners of those securities, typically financial institutions, take that money and attempt to turn a profit by loaning it out.If borrowers use the money to buy goods and services, the providers of those goods and services will take the money
receive and deposit it at their banks, leading to an increase in private-sector deposits.Banks receiving those new deposits will increase their lending accordingly. If the new borrowers also use the borrowed moneyto buy goods and services, the providers will again take the proceeds and deposit them in a bank account, driving further growthin private-sector deposits.Both private-sector deposits and lending continue to increase as this process is repeated. However, banks cannot lend out theentire amount of new deposits because a portion must be set aside as statutory reserves. This creates a leakage in the cycle of increasing deposits and lending equal to the increase in statutory reserves.Consequently, the process of deposit growth will continue until the entire amount of liquidity supplied by the central bank is setaside as reserves. If the statutory reserve ratio is 10%, the deposit growth process will end once the liquidity injected by thecentral bank has been transformed into deposits worth 10 times the initial amount.The money supply data, composed mostly of bank deposits*, are closely watched by market participants because of their closerelationship to GDP and price levels. The numerical relationship between the money supply and the initial liquidity injected bythe central bank is called the money multiplier. In the previous example, the multiplier would be 10.
*Strictly speaking, the money supply includes bank deposits, currency, and coins.
Money supply has shown little change despite sharp increase in liquidity
What actually happened, however, is quite different. Market liquidity in the US and the UK almost tripled. But the money supply,which represents funds actually available for use by the private sector, has increased little if at all since the financial crisis in2008.Figure 1 shows the US monetary base (ie liquidity) along with the money supply and commercial bank loans and leasesoutstanding (ie private-sector credit), rebased so that August 2008 = 100. The graph confirms that these three indicators movedin unison, as the textbooks predict, until the Lehman-inspired financial crisis. Since then, however, liquidity has surged to nearly300, yet the money supply stands at 115.As explained above, growth in the money supply should entail a corresponding increase in bank lending under ordinaryconditions. Yet lending had fallen to 90 by April 2011.In other words, the money supply—which supports consumption and investment—has exhibited little growth during this period.We cannot expect an expansion of the economy or an acceleration of inflation without an increase in the money supply. There isno reason why inflation—apart from imported inflation—should increase at a time when the money supply is not growing.The inflation currently being reported around the world is of the imported variety, typically involving oil and food. “Home-grown”inflation, like the core deflator for personal consumption expenditures shown in the bottom portion of Exhibit 1, remainssubdued.