Focus
February 10, 2023 | 13:43
Whole Lotta Liquidity
Economics
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Whole Lotta LiquidityUnderlying inflation is proving to be stubborn on both sides of the Canada-U.S. border. For the Bank of Canada’s preferred core inflation metrics, the CPI-Median was 5.0% in December with the CPI-Trim at 5.3% (Chart 1). These are barely below their peaks (5.1% in November and 5.5% in June-July, respectively). The three-month annualized changes were 4.3% and 3.6%, respectively, pointing to further disinflation. However, there’s currently not much ebbing momentum among these short-term trends (three months earlier, the annualized changes were 3.5% and 3.9%, respectively), highlighting potential constraints on the degree of additional disinflation. |
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Meanwhile, for the Federal Reserve, core PCE inflation was 4.4% in December, down from the 5.4% peak in February-March. With the three-month change at 2.9% annualized, further disinflation is again indicated. However, the degree of said disinflation is also looking limited. Excluding falling goods prices and soon-to-be-falling housing costs, ‘core-core’ PCE inflation (Chair Powell’s new favourite metric) was 4.0% in December, down from the 5.1% peak last November-December. But the three-month move was a stubborn 3.9% annualized (and, three months earlier, it was 3.5% annualized). The Fed’s core-core metric illustrates well why underlying inflation is stubborn on both sides of the border. The focus on core services ex-housing emphasizes several forces now driving inflation. First, there’s wage gains and the ability of businesses to keep paying higher wages. Next, there’s consumer demand strength and how easily firms can pass along higher costs to their customers. |
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Finally, there’s price hikes and the ability of consumers to keep paying higher prices. Furthermore, because the core-core metric already excludes spending on things like groceries and gasoline along with clothing and housing, outlays that exhaust most of the budget for many households, it’s also picking up the ability of some consumers to keep paying higher prices on discretionary spending specifically. For both businesses and consumers, the above abilities are bolstered by elevated levels of liquidity or ‘cash in the bank’. And, as these waves of liquidity ripple through both economies, they are complicating the BoC’s and Fed’s efforts to restore price stability. American moneyIn the U.S., the M2 money stock, excluding currency, measures all deposits in the banking system and in retail money funds (Chart 2). It was boosted after the pandemic’s onset by the government’s direct income support for individuals, families and firms. Initial restrictions on spending, combined with the fact that most Americans continued earning the same income, padded these balances further. These all resulted in a soaring personal saving rate and the accumulation of a massive stock of ‘excess’ savings. (In next week’s Focus publication, my colleague Sal Guatieri will dive deeper into the excess savings phenomenon for both the U.S. and Canada.) |
Then, as the U.S. economy reopened amid a mix of strong demand and constrained supply, business revenues and profits rebounded sharply and padded liquidity further. The M2 data do not distinguish between consumer (personal) and business (non-personal) account balances. We can get an approximate split from the Flow of Funds accounts. Among all sectors, the share of outstanding deposits (and currency) and money market fund shares owned by the household sector tops 63%. Relative to the pre-pandemic growth trend, excess liquidity peaked at $4.6 trillion in January 2022 and, since March, balances have been dropping in absolute terms (for a cumulative $570 billion). Liquidity currently sits at $3.5 trillion above trend, representing 13.4% of nominal GDP. Even allowing for stronger trend growth (perhaps due to an increased desire to hold liquidity because of economic uncertainty), there remains a massive amount of excess liquidity in the hands of consumers and businesses. Canadian cash |
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In Canada, the M2+ monetary aggregate, excluding currency in circulation, also measures all deposits in the banking system and in money market mutual funds (Chart 3). Like its American counterpart, it was boosted after the pandemic’s onset by the government’s direct income support for individuals and firms, but to a relatively smaller extent. And, it was padded by more onerous restrictions that dampened spending. Similarly, as the Canadian economy reopened, rebounding business revenues and profits boosted balances further. The M2+ data do not distinguish between consumer (personal) and business (non-personal) account balances, but a split is available for deposits at chartered banks alone (which make up about 80% of total deposits in the banking system). Personal deposits make up just over half (51%) of this total. |
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Relative to the pre-pandemic growth trend, excess liquidity peaked at almost $345 billion in February 2022 and balances have yet to start dropping in absolute terms. Liquidity currently sits close to $310 billion above trend, representing around 11% of nominal GDP. However, for both Canada and the U.S., culling total deposits and money market funds from the monetary aggregates likely overstates the amount of ‘available’ excess liquidity in the hands of consumers and businesses. Some of these balances are investments. In Canada’s case, think of fixed-term and other deposits in tax-sheltered accounts or other balances intended as longer-term (non-sheltered) savings. |
Focusing on deposits at the chartered banks, total balances on the personal side have been picking up (Chart 4), sitting about $175 billion above trend. However, the recent pickup has been on the term deposit side. Demand and notice deposits, a better reflection of ‘available’ excess liquidity, are around $110 billion above trend, but are down $84 billion from the December 2021 peak. In absolute terms, these balances are down $60 billion from the June 2022 peak. On the nonpersonal side (Chart 5), although these choppier balances hit a new high in November (the latest data), excess liquidity peaked a year earlier at almost $180 billion and has since slipped to about $150 billion. Again, isolating demand and notice deposits, they are around $100 billion above trend, but are down $115 billion from the January peak. In absolute terms, balances are down $77 billion from the June 2022 peak. For both personal and nonpersonal deposits, ‘available’ excess liquidity is falling, but it remains elevated. Why these amounts matterThere’s an adage that “the cure for higher prices is higher prices”. The combination of strong demand and constrained supply sparked inflation in the first place. However, inflation erodes purchasing power that, in turn, reduces real spending given budget constraints, all other things equal. This moves demand into better balance with (and possibly below) supply, addressing the root cause of inflation. But other things are not equal for some consumers and businesses with excess liquidity. |
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This ‘cash in the bank’ gives some households an ability to keep paying higher prices for goods and services for longer than they otherwise would. It gives some firms an ability to keep paying higher wages and other production input costs for longer than they otherwise would. Meanwhile, excess liquidity also provides a means to mitigate the impact of higher interest rates (e.g., for some consumers and businesses, higher borrowing costs won’t deter a new vehicle purchase or an inventory restocking). In short, excess liquidity could be propagating pressures and pushing core inflation on a more stubborn path, much to the chagrin of the central banks. There was a time when both the Fed and the BoC followed the monetary aggregates very closely; they even had formal targets for their growth rates. However, financial and banking innovation blurred the relationship between money supply growth and inflation and nominal GDP growth. Former Bank of Canada Governor Bouey said famously: “We didn’t abandon the monetary aggregates, they abandoned us”. However, we suspect a bit more attention is being paid these days to the money stock owing to the potential impact of excess liquidity on the inflation process, if only from a risk management perspective. One can’t help ponder Milton Friedman’s even more famous phrase: “Inflation is always and everywhere a monetary phenomenon…” Taking away the lingering impacts of shortages and other supply chain disruptions, this could now be bang on. |