Fed tightening is not a near-term threat

It's no secret that an aggressive tightening of monetary policy can be a real threat to the health of the economy. But even if the Fed surprises us with a 50 bps hike in short-term rates next month and even 4-5 more hikes by year end, policy will still be extremely accommodative. It's going to take a long time for Fed policy to become "tight," much less too tight. If this proves to be the case, then by inference inflation is very likely to be higher than the market expects, and for longer.

As I've noted in recent posts, there is one huge thing that is missing in all the buzz about inflation: the surging M2 money supply. And in virtually all the discussions about inflation, nearly everyone fails to mention that a widespread increase in many prices can only happen when there is a clear increase in the supply of money. If the Fed is doing its job, the supply of money should equal the demand for money. But if the Fed allows the supply of money to exceed the demand for money, then that's equivalent to boosting everyone's spending power: extra money is needed to drive a general increase in the supply of money. Without extra money in people's pockets, higher prices for energy (for example) mean that consumers have less money to spend on other things. But when energy, commodity, auto, home, and food prices rise significantly, that is virtual proof that there is an excess of money in the system. Which can only be remedied by the Fed adopting policies that increase the demand for money and reduce the supply of money.

What follows are some handy charts to use for reference as Fed policy progresses. 

Chart #1

Chart #1 is the best way to see whether monetary policy is tight or not. Notice the patterns that have repeated over the decades (with the exception of the sudden plunge in GDP two years ago): prior to every recession, the real Fed funds rate has surged to at least 3-4% and the slope of the yield curve has gone flat to negative. Those are classic hallmarks of tight money. Why? Because the Fed needs to raise real short-term rates to a level that discourages borrowing and encourages saving (i.e., to a level that boosts the demand for money). As real rates move higher, the demand for money becomes intense, liquidity becomes scarce, and marginal firms get squeezed. The bond market realizes that economic weakness is spreading and begins to anticipate a reduction in the real Fed funds rate in the future—so long term rates fall to or below the level of short-term rates. Currently, those two variables are not even close to suggesting that monetary policy is or is about to become tight. 

As a first-pass estimate, the Federal funds rate needs to at least equal the rate of inflation for monetary policy to become restrictive. If short-term rates are below the level of inflation, that by itself serves to weaken the demand for money (and encourage borrowing), thus allowing inflationary psychology to persist. If we don't see the growth of M2 start to decline soon (it's currently growing at double-digit rates), then you can expect to see inflation of at least 7% for some time to come. Unfortunately, the Fed only releases data on the money supply once a month; we will have to wait a few more weeks to see what happened in January.

Chart #2

Chart #2 shows the bond market's expectations for the future course of inflation (green line). Right now the market expects the CPI to average about 2.8% per year for the next 5 years. That's somewhat above the Fed's target, but only modestly. That means the market realizes inflation is going to be above average for the next few years, but the market is still convinced the Fed is not going to lose control of the situation. (The Fed defines "losing control" as "inflation expectations becoming unmoored.") I'm all for trusting the Fed, but I like to verify as well, and so far, they are failing on that score.

Chart #3

Chart #4

Small businesses far outnumber large businesses, so it's important to track what the owners of small businesses are thinking. That's shown in Chart #3, which measures the general level of optimism among small business owners. Optimism has fallen in recent years, but is only marginally lower than its long-term average. Things could be better, but they're not terrible yet. The economy is still quite likely to continue growing, since job openings are exceptionally plentiful, and there are still plenty of people willing to go back to work, as shown in Chart #4. Things could be a lot worse. 

Chart #5

Chart #5 shows the major problem cited by a majority of small businesses: prices are rising big-time. 

Chart #6

Over one-fourth of small businesses report paying their workers more (see Chart #6). Although the number dipped last month, it is still exceptionally high. As Chart #5 also shows, inflation today shares a lot in common with inflation in the late 1970s. 

Chart #7

It's rather impressive that a wide range of prices—industrial metals, agriculture prices, energy prices, home prices, etc) are up, and up significantly. In the past two years, many almost doubled in price. Chart #7 shows raw industrial commodity prices (red line) that have increase almost 50% since just before Covid hit. It's also interesting to note that in the past, commodity prices tended to move inversely to the strength of the dollar: a strong dollar depressed prices, while a weak dollar helped drive prices higher. These days that relationship seems to have reversed: the dollar is relatively strong, but prices are surging. I think this reflects a lot of excess money coupled with a general revival of the many activities (e.g., construction, new plant and equipment) that were put on hold during Covid. 

Chart #8

Chart #8 shows 2-yr swap spreads in the US and the Eurozone. Swap spreads are a highly liquid indicator of a) general liquidity conditions, b) the health of the economy, and c) the outlook for corporate profits. US swap spreads currently trade about smack in the middle of what might be considered a "normal" range. Eurozone swap spreads are a bit elevated, which probably reflects the fact that the outlook for the Eurozone economy is decidedly less optimistic than the US. No surprise there: the US stock market has outperformed the Eurozone stock market by some 85% in the past decade. A normal level of swap spreads here suggests abundant levels of liquidity and signal a healthy outlook for the economy and corporate profits.

Chart #9

Finally, Chart #9 shows 5-yr Credit Default Swap rates. Like swap spreads, these are highly liquid indicators of the outlook for corporate profits. Although spreads have risen a bit (out of possible concern that the Fed might tighten too much or too fast), they are still well within what might be considered a normal range. The Fed has yet to inflict any damage on the economy's fundamental indicators.