M2 still points to lower inflation

The Fed recently released the March money supply numbers, and the story hasn't changed. M2 surged from early 2020 through early 2022, thanks to $6 trillion of deficit spending that was effectively monetized. Since its peak in April '22, M2 has declined by almost $1 trillion. This all adds up to the biggest seesaw in U.S. monetary history. As the dust continues to settle we see that a lot of the excess growth in M2 has been absorbed by a bigger economy and suppressed by higher interest rates, which have boosted the public's willingness to hold onto the extra money. The question now is not whether inflation will rise, but rather how much further it will decline. 

Chart #1

Chart #1 shows the history of M2 growth (plotted on a logarithmic y-axis so as to show constant rates of growth as straight lines). The huge bulge in M2 which began in Q2/20 was fueled by about $6 trillion in Covid "stimulus" checks which were effectively monetized (not borrowed, but printed) and largely sat in people's checking accounts for almost two years. (Prior to this, deficit spending by Treasury was routinely financed by selling bonds, which created no new money as a result.) The "bulge" in M2 rose to a high of $4.7 trillion in Dec. '21, and has now fallen by almost two thirds. This was the result of negative growth in M2 and ongoing growth in the economy. 

Chart #2

Chart #2 shows the growth of currency in circulation. This is a fairly good measure of money demand, since no one holds onto currency without a reason to do so. Excess, or unwanted currency is easily returned to the banking system in exchange for interest-bearing deposits. This chart demonstrates the significant increase in money demand from 2020 through late 2021, a time when uncertainties were running rampant and it was difficult to spend money. Since early 2022 money demand by this measure has returned to "normal." Rising money demand kept the bulge in M2 from being inflationary, while declining money demand coincided with an increase in inflation. In short, for the past two years the increase in inflation that has proved so distressing was simply the result of unwanted money being spent: too much money chasing too few goods. Money demand has apparently returned to more normal levels now, so, with a lag, inflation is likely going to continue to decline.

Chart #3

Chart #3 is my definition of money demand: M2 divided by nominal GDP. This is best thought of as the percentage of total income (GDP) that the public chooses to hold in the form of readily spendable cash (M2). Here we see that money demand—after surging in the wake of the Covid panic—is rapidly returning to what might be termed normal. 

Chart #4

Chart #4 compares the year over year growth of M2 with the year over year change in the CPI, which has been shifted to the left by one year to suggest that there is a one-year lag between changes in M2 and changes in inflation. The red asterisk at the Mar. '24 mark is the rate of CPI inflation ex-shelter (see this post for a more detailed explanation). It would appear that the lag has lengthened a bit to perhaps a year and a half. That further suggests that given the decline in M2 we are likely to see further declines in inflation over the balance of this year. 

GDP update: moderate growth and disinflation continue

Markets have over-reacted to today's first quarter GDP stats. Quarterly numbers are by nature volatile; it's more important to look at them in a broader context, which the following charts provide.

Chart #1

The first estimate of Q1/24 GDP growth came in weaker than expected (1.6% vs 2.5%). But as I see it, that merely corrected for some stronger-than expected numbers in Q3 and Q4. On balance, and as Chart #1 shows, real GDP is growing at about a 2.2% annual pace. It's actually a bit below the 2.2% trend growth pace which began in mid-2009. It's unremarkable, as I've been saying for a long time. What's really remarkable is that the economy today is about 20% smaller than it could have been had it continued the 3.1% growth trend that prevailed from 1966 through 2007. A lot of money has been left on the growth table! That should be the big story. 

Chart #2

Chart #2 shows the year over year change in the GDP deflator, the broadest measure of inflation that exists. On a quarterly basis, the deflator grew at a 3.7% annualized rate, which was a bit higher than the market's 3.4% expectation. Does this qualify as "hot"? Hardly. On a year over year basis the deflator rose only 2.4% and there is every reason to think that it will continue to moderate over the course of this year, for the same reasons I have argued that CPI inflation will moderate.

On balance, I see no reason to worry about a near-term recession, nor to worry that the Fed has not done enough to tame inflation. Swap and credit spreads remain very low, the banking system is flush with liquidity, financial conditions are quite healthy, the stock market is healthy, the dollar is strong, unemployment claims are low, job gains continue at a reasonable pace, and there is little risk of an imminent increase in tax or regulatory burdens.

Belated March CPI analysis

I've only recently returned from several weeks in Argentina. I didn't have access to my charts, and besides, I was rather more interested in people, food, and wine than in blogging. Time now to catch up on the market's latest focus: Is inflation still stubbornly high? Does the Fed need to tighten more?

The March CPI release was, in retrospect, the one that apparently convinced the Fed and the market that "disinflation has stalled." More recently, the market, with encouragement from numerous Fed governors, has come around to thinking that instead of cutting rates five times by the end of this year, we might see, at best, one cut, because the Fed has more work to do. "Higher for longer" is now the interest rate mantra that is driving the market; it's made people nervous, so an equity market correction is underway.

You won't be surprised to learn that I disagree. I still think the great inflation bubble that started three years ago has long since popped. And the main reason inflation is still marginally higher than where the Fed would like to see it is the way shelter costs are calculated. I think the following charts make that clear.

Chart #1

Chart #1 compares overall inflation to inflation less its shelter component, which is about one-third of the total. Both are calculated on a 6-mo. annualized basis, which is the best way to see if recent developments mark a change in the broader trend. My first take when looking at this chart is that if there is an inflation problem in today's numbers, it pales in comparison to the numbers we saw in the 2005-2009 period. 

Looking closer, I note that the 6-mo. annualized rate of inflation less shelter has averaged 1.6% for the past 16 months, and it has been more than 2.0% in only four of those months. Moreover, there is no sign of any meaningful recent acceleration: it has averaged only 2.01% over the past 4 months and it was 2.06% in March '24. As for the overall CPI, it has averaged 3.3% over the past 16 months, and it was 3.3% in March '24. The difference between the two is due entirely to shelter costs, which, arguably, have been artificially inflated by the way BLS calculates them.

Chart #2

Chart #2 shows that the year over year increase in shelter costs as calculated by the BLS is driven almost entirely by the year over year change in nationwide housing prices 18 months prior. (The red line has been shifted to the left by 18 months, and the two lines match up almost exactly.) Even though housing price inflation has dropped significantly from its peak two years ago, and nationwide rents have been flat to down over the past year, the BLS calculates that shelter costs currently are rising at the rate of 5.9% per year. If the relationships in this chart hold, then the rise in shelter costs will reach a low point this coming October (which is the point where the blue line falls to zero). In other words, shelter costs will almost certainly continue to decline every month from now until October, and that will subtract significantly from the increase in the overall CPI.

Inflation is not a problem. The Fed once again is late to the party, as usual. If the Fed keeps short-term interest rates higher for longer it will only push inflation lower, and there's nothing necessarily bad about that. In any event, I'm willing to bet that interest rates don't remain at current levels for as long as the market is currently forecasting. At some point the Fed is going to figure out that it's done enough.