Sunday, May 31, 2009

What is Inflation?

Webster's Dictionary defines inflation as "a continuing rise in the general price level usually attributed to an increase in the volume of money and credit relative to available goods and services."

That's not a bad definition. In fact, Milton Friedman postulated that
"inflation is always and everywhere a monetary phenomenon." Rising price levels result from inflation, a subtle but important distinction from how the topic is presented in the press.

Not too long ago, The Federal reserve considered money supply the gauge of monetary policy. The weekly release of the money supply numbers was a highly anticipated event on Wall Street. The Fed has since changed its policy to monitor and modify interest rates to control money supply.

So, it is clear that determining the supply of money is paramount to declaring inflationary or deflationary episodes. One more distinction before moving on: deflation would be described a a fall in money supply, disinflation would be described as a declining rate of inflation.

M1 is the most narrow measure of money supply.

M1 includes funds that are readily accessible for spending. M1 consists of: (1) currency outside the U.S. Treasury, Federal Reserve Banks, and the vaults of depository institutions; (2) traveler's checks of nonbank issuers; (3) demand deposits; and (4) other checkable deposits (OCDs), which consist primarily of negotiable order of withdrawal (NOW) accounts at depository institutions and credit union share draft accounts.

M2 includes additional financial products.

M2 includes a broader set of financial assets held principally by households. M2 consists of M1 plus: (1) savings deposits (which include money market deposit accounts, or MMDAs); (2) small-denomination time deposits (time deposits in amounts of less than $100,000); and (3) balances in retail money market mutual funds (MMMFs).

M3 is an even broader measure of money supply.

M3 consists of M2 plus (1) balances in institutional money market mutual funds; (2) large-denomination time deposits (time deposits in amounts of $100,000 or more); (3) repurchase agreement (RP) liabilities of depository institutions, in denominations of $100,000 or more, on U.S. government and federal agency securities; and (4) Eurodollars held by U.S. addressees at foreign branches of U.S. banks worldwide and at all banking offices in the United Kingdom and Canada. Large-denomination time deposits, RPs, and Eurodollars exclude those amounts held by depository institutions, the U.S. government, foreign banks and official institutions, and money market mutual funds.

The growth of the repurchase agreement market was a major component of the expansion of bank balance sheets. In addition, the other components of M3 provide insight into the behavior of corporations and the direction of major (and perhaps fickle) money flows.

On March 16, 2006, The Fed published its last tally of M3. An announcement was made the preceding November that the incremental guidance that M3 provided was not worth the cost of acquiring the additional data. According to the press release, M2 provided sufficient data and M3 had not played a roll in decision making for some time.

This struck some market watchers as odd. Some believed that The Fed wanted to obscure the true nature of its policies. Let's take a look at whether or not this is the case. To be continued....

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