Money Multiplier: A Warning Sign to the Stock Market

I have written about the exorbitant expansion of the FRB’s balance sheet. An equal important measure is how fast that money injection is multiplying in the economy. Putting it simply, when the FRB injects money in the economy it ends up creating additional money via the banking system. For example, assume the FRB injects $100 in the economy, and assume that banks are required to hold 10% on demand and lend the rest, that would translate in an additional $900 dollar created out of thin air ([100/0.1] – 100). In this example, the money multiplier would be 10%. In the real world there are other variables to consider, but broadly speaking, the example is indicative of how the money creation process works and the importance of taking into account the rate of multiplication. It goes without saying that the extra funds created would chase other goods, and what we would expect to see is prices rising somewhere in the economy. And this is what we have seen starting about May 2020. I have estimated the money multiplier as the ratio between M1 and the Monetary Base. 

The graph below shows you the time period from April 2018 to the present. What is obvious that the money multiplier was picking up speed during most of 2018, which fueled the stock market bull run prior to the government-induced shutdown of the economy. The economic shutdown had the obvious effect of decelerating the money multiplication process. But what becomes obvious is that the money multiplier has picked up speed in particular during the latter part of 2020. This has translated at present in record setting numbers in the equity market. It is critical to understand that the money multiplier metric is backward-looking, so we must make some sort of assumption about the future. What we know is that the money creation process is still continuing and that gives support to the continuing rise of the equity market in the very short term (which I define here in the next 2 months), all things being equal. However, as this rate continues to decline, it will be another sign that a correction in prices is soon coming.  

Money Multiplier

Data Source: FRB's H.6 Statistical Release