M2 growth slows, but it's still too fast

This is a quick post, but on a very important and almost completely overlooked statistic: the growth of the US money supply. I have been highlighting this for at least the last 18 months. Until recently, money growth was at all-time and very inflationary highs—well into the double digits. This all but guaranteed that the inflation which appeared to be ignited by supply-chain bottlenecks would instead be durable and pervasive.

With the release today of the M2 numbers, I'm breathing a bit easier. The Fed is still extremely accommodative, but on the margin monetary policy is becoming less so. Monetary policy is far from being "tight" but it is now becoming "less easy."

The tapering of Fed asset purchases is good, but they need to reverse course as soon as possible, and they need to raise rates much more than they have been hinting up until recently. It's encouraging to see several members of the FOMC saying the same thing, and the market has been reacting appropriately, by bidding up short-term interest rates rather aggressively. 5-yr Treasury yields—a proxy for what the market expects the Fed funds rate to average over the next 5 years, have risen by 80 bps so far this month. And despite this, the stock market has rallied.

In the past I have rarely agreed with Larry Summers, but in an interview last week with Bloomberg, he expressed similar views. We both think that as a first approximation, the Fed needs to raise short-term rates to at least 4-5%. I think we would both agree that ultimately, the Fed needs to raise rates until they are above the rate of inflation. Negative real rates are inflationary, since they make borrowing (which is what expands the money supply) profitable.

In any event, the market is saying what I've said all along: if there is a good reason for the Fed to raise rates, and they do so, this is good news, not bad news. We are still far from seeing conditions that would signal an imminent recession. Credit spreads are still relatively low, swap spreads are square in neutral territory, and the yield curve is still positively sloped. There is no sign that liquidity is in short supply—and that's all-important. This economy is not being starved of liquidity, so it's very unlikely to suffer a collapse. It's still worrisome, however, to see commodity prices moving higher, and real rates still deep in negative territory. 

We haven't seen the end of this story.

Chart #1

Chart #1 is my choice for "most important chart." It shows the growth of M2—the best measure of the money supply—less the currency component, which is about 10% of M2. I've subtracted currency because whatever the supply of currency is, it is always equal to the demand for currency, and thus it's not inflationary. But if the growth of the rest of M2 exceeds the demand for it–which I suspect is true—then this is inflationary. Regardless, it is very encouraging to see that in the past few months the growth of this key indicator has fallen from 12-13% annual rates to now 8-9% annual rates. That's still rapid, but on the margin it represents change for the better. A good portion of the slowdown in recent months, I should note, is due to downward revisions of previous data.

We'll have to see more such declines before we're out of the inflation woods, of course, but anything that is positive in today's environment is quite welcome.