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The whole point of tightening monetary policy is to increase the demand for money and/or decrease the supply of money at the expense of other things. Tighter monetary policy today serves to balance the supply of money with the demand for money, and that is what will deliver low and stable inflation. Higher interest rates increase the appeal of holding cash and cash equivalents, and at the same time they discourage the borrowing and spending of money (and thus tend to depress prices). Unfortunately, nobody knows (not even the Fed) how high interest rates have to rise in order to slow and ultimately reverse the recent rise in inflation.
So we (and the Fed) must instead rely on old-fashioned methods such as watching prices. Continuously rising prices are a clear sign that interest rates are too low and/or monetary policy is too easy. Falling prices, on the other hand—if sufficiently widespread—are a pretty good indicator that monetary policy is gaining traction and thus helping to bring inflation down.
Such is the case today. So far this year we have seen significant declines in a number of prices and markets, and here are just a few that are down significantly: stocks, commodities, foreign currencies (see Chart #1 in my last post), TIPS, bonds in general, and used cars, the latter of which have declined by 18% in real terms (see Chart #1). Though not down year to date, gasoline prices are down 27% since their peak last June.
Chart #1
Since reliable measures of housing prices take months to show up, it's best to look at indicators that update more frequently, such as mortgage refinancings, which have plunged to levels not seen since 2000, and new applications for mortgages, which have dropped by 43% since the peak of early 2021. Both of these are symptomatic of what we would expect from higher interest rates: reduced demand for borrowed money. The rise in housing prices which began about 18 months ago coupled with sharply higher mortgage interest rates (Chart #2) has caused housing affordability to plunge to levels not seen in over 30 years (see Chart #3), and there is little doubt this has arrested the boom in the housing market, which can be seen in a sharp decline in applications for new mortgages (Chart #4). Home prices are almost certainly falling on the margin and we saw a hint of that in the August numbers.
To be sure, even though the bloom is off the housing rose, and prices are weakening on the margin, rents have been slow to catch up to the rise in prices. I would expect to see rents rising for at least the next 9 months, and this will add to measured CPI inflation. But rents are a lagging, not a leading indicator (if for no other reason than that rents are infrequently adjusted as leases expire); the important thing is housing prices which change daily. Rents don't cause inflation, and neither do wages; only excess money causes inflation, and there seems to be a lot less of it recently, which is great news.
Chart #2
Chart #3
Chart #4
TIPS prices are down sharply because real yields are much higher, having risen from a low of -2% on 5-yr TIPS to now 1.2% (Chart #5). That's because TIPS are an inflation hedge, and in the presence of tight money the demand for inflation hedges should decline. This might be the best chart of all, because the "tightness" of monetary policy can be measured directly by the level of real yields. There is no question but that the Fed's policy stance has gained traction significantly and is thus affecting markets all over the world. Icing on the cake: Chart #5 also shows how inflation expectations have declined this year, from a high of 3.7% in early March '22 to now 2.5%.
Chart #5
Meanwhile, supply chain bottlenecks are clearing up rapidly, thus facilitating the supply of goods, and in turn tending to lower their prices. For example, the Baltic Dry Index (an index of shipping coasts in the eastern Pacific) has fallen by 72% since its peak last October. Where there used to be over a hundred container ships anchored off the coast between San Clemente and Palos Verdes waiting to unload, there are now just a handful.
In Chart #6, note how builder sentiment has fallen dramatically in recent months. This likely reflects decreased housing demand, soaring mortgage rates, and softer prices, and that further presages a slowdown in housing starts (and weaker demand for construction materials), some of which we have already seen.
Chart #6
A CPI report is old news by the time it's released. Indicators such as the above tell you where the CPI is headed.
30 comments:
Scott,
How long do you believe the lag is between M2 growth and when it shows up in the real economy?
M2 usually follows Nominal GDP growth, so a 4 to 5 percent growth rate of M2 would be consistent with two percent inflation correct? Right now it's basically flat, should the Federal Reserve pause now with real tips rates at 1% ?
The focus on the deceleration in prices is misleading and misunderstood. Money flows might have peaked, but real growth will fall faster than inflation. It is axiomatic. Long-term money flows, proxy for inflation, move slower than short-term money flows, proxy for real output. It's just math.
The economic engine is being run in reverse. Income inequality will accelerate. Economists are nuts. We have Karl Marx’s rentier capitalism. Why do you think murder rates are rising? Social behavior is pre-programmed.
George Bailey’s “Its a Wonderful Life” was derived by putting savings back to work, where velocity was 2/3 and money was 1/3. The banksters seeking to gain a larger portion of the loan pie, drove up Reg. Q ceilings, inducing nonbank disintermediation. The economic engine is now being run in reverse.
"The 30-year Bankrate.com mortgage rate has more than double since last summer, spiking by 3.32%. Far more than the corporate bond index yield (which moved 3.14% higher) or the 10-year treasury yield which is “only” 2.25% more than it was. This is a reasonable comparison, given all three of these have similar duration."
"Although there is now a CPI downtick in the rear-view mirror, base effects (the CPI increases that will remain in the year-over-year calculations for months to come) ensure that the headline CPI growth numbers will remain elevated for at least the remainder of this year. For example, even though inflation most likely has peaked on an intermediate-term basis, the numbers that will stay in and drop out of the year-over-year calculations each month mean that there is almost no chance of the year-over-year CPI growth rate dropping below 6% sooner than the first quarter of next year"
Economists are stupid. Vi, the income velocity of funds, falls (reflecting money demand) while Vt accelerates, the transaction's velocity of funds (reflecting an increase in money flows). Vt was used in American Yale Professor Irving Fisher's truistic "equation of exchange". N-gDp is a subset of money flows.
It's exactly as Lawrence K. Roos, Past President, Federal Reserve Bank of St. Louis and past member of the FOMC (the policy arm of the Fed) as cited in the WSJ April 10, 1986:
"...I do not believe that the control of money growth ever became the primary priority of the Fed. I think that there was always and still is, a preoccupation with stabilization of interest rates".
Not so liberated, Chairman Paul Volcker, in a 1982 WSJ article was quoted as saying that he “believes in principle the Fed should pay interest on reserves held against deposits on rounds of equity” and “as a matter of principle favors payment of interest on all reserve balances”.
” as income velocity that cannot but impress anyone who works extensively with monetary data” (Friedman, 1956, p. 21).
Or (WSJ, Sept. 1, 1983)
Friedman bastardized the equation of exchange that he had printed on his car license plate. The transactions’ velocity of money has sometimes moved in the opposite direction as income velocity, as in 1974-1975 or 1978.
re: “the ‘mystery of the missing money’ (Goldfeld et al., 1976).
The transactions velocity of money was a statistical stepchild. I.e., virtually all the demand drafts that were drawn on DFIs, the CUs, S&Ls, etc., cleared through DDs – except those drawn on MSBs, interbank & the U.S. government. That is all "new payment methods" clear through transactions' deposits.
Atlanta Fed Cuts Q3 GDP Estimate to Just +0.3% After Housing Data
@Classical Monetarist - re: "lag is between M2 growth and when it shows up in the real economy"
Contrary to the Keynesian economists at the FED, banks don't lend deposits. Therefore, M2 is misleading. M2 velocity, Vi velocity, falls as interest rates rise.
See: Dr. Philip George - "The Riddle of Money Finally Solved"
http://www.philipji.com/riddle-of-money/
See: “Should Commercial Banks Accept Savings Deposits?” Conference on Savings and Residential Financing 1961 Proceedings, United States Savings and loan league, Chicago, 1961, 42, 43
You see, the distributed lag effect of money flows are covered up. The FED doesn’t know about the distributed lag effects. That’s why the FRED database doesn’t permit those mathematical constants, historic rates-of-change. Money flows are ex-ante calculations, not ex-post calculations. You can’t run a regression test against old data.
All monetary savings originate within the payment’s system. Demand deposits are just shifted into time deposits. The banks collectively pay for the deposits that they already own.
Hiking rates induces nonbank disintermediation, where the banks outbid the nonbanks for loan funds. The opposite scenario cannot exist. This destroys the transaction’s velocity of funds. I.e., it reduces R-gDp relative to N-gDp. It is backwards.
A larger proportion of savings have been dissipated in financial investment (mal-investment), e.g., the stock market (the transfer of title to existing goods, properties, or claims thereto).
There should be subsidized mortgage rates for new residential construction.
BTW, China is moving into deflation.
As a result of an unprecedented bout of coordinated fiscal and monetary easing, the US has exported the inflation spike it created and now it has started to export recession.
Then, when the dust settles down, isn't possible that 'we' get back to the 2019 trajectory?
At least the yield curve suggests so..
Positive comment for you, Benjamin: Over time, the US will come out ahead.
Increases in DFI loans and investments [earning assets/bank credit], are approximately the same as increases in transaction accounts, TRs, and time deposits, TDs, [savings-investment deposits/bank liabilities/bank credit proxy] excluding IBDDs.
That the net absolute increase in these two figures is so nearly identical is no happenstance, for TRs largely come into being through the credit creating process, and TDs owe their origin almost exclusively to TRs - either directly through transfer from TRs or indirectly via the currency route or through the DFI's undivided profits accounts.
Bank Credit:
2022-05-25 17025.9423
2022-09-07 17286.2629
Having caused inflation, leaders now want a recession to curb inflation?
And not only that, get back to 2% inflation. Pronto.
Eat this cake and starve later, troops!
Carl-
Any positive comments are welcome.
"Wake me when the recession is over."
The message from the markets this morning is that the Fed has gone too far. The dollar is reaching extremely strong levels; gold is collapsing, real yields are soaring. Too much! Powell is going to have to eat his words pretty soon.
It does appear that you change your opinion about the FED and the need to raise rates to combat inflation whenever the market tanks. Have you bought a steak at a nice restaurant lately or filled up a grocery cart? Average Americans are certainly feeling the effects of inflation, and I don't think your charts can make that go away. Nevertheless, thank you for this blog. It's always an interesting read.
Doesn't old fashioned business competition push prices down? What should the government do to increase competition?
Regarding Fred's steak, don't 4 meat packing companies control something like 80 percent of the meat market?
Levity time:
An engineer, and farmer and a central banker are whisked by a UFO to the planet Mergatroy, and then returned to Earth.
The engineer exclaims, "You should've seen it! Buildings a mile into the sky, and airships that traveled at 10 times the speed of sound. EVs with 2000-mile ranges!"
The farmer exclaims, "And oranges the size of watermelons, and square miles of crops harvested by robot tractors!"
The central banker sniffs. "I don't know that it was all that great. Mergatroy has an inflation rate of 3.6%"
"Eat this cake and starve later, troops!"
This inflation episode has a "Let them eat cake" flavor (reference to Marie-Antoinette and the 'elite' disconnect of the time).
See:
https://www.cbo.gov/system/files/2022-09/58426-Inflation.pdf
-especially figures 1 and 2, income after transfers and taxes
-note also the likely underestimation of the CPI-essentials (food energy) impact on lower income quintiles
-in 2022, the inflation (cost of living crisis) is slowly trickling up
-----
For a while now, the Fed-Treasury complex has enjoyed the positive short term effects of the policies involving debt and easy money ie asset inflation and more recently and for a short time (2020-1) the positive aspects of consumer inflation where government subsidies allowed regular folks to pay up the passthrough corporations applied.
But now, they somehow have to face the negative and not so unintended consequences.
For 17 straight months now, real wages have registered negative year over year growth.
You can't have your cake and eat it too, eventually, even if you're into balance sheet expansion.
Scott, great analysis. I wonder what you think of Wesbury's comments regarding abundant reserves vs scarce reserves model and whether that reduces the impact of bumping up short rates to combat inflation. Thanks
Jim Chandler
https://www.ftportfolios.com/Commentary/EconomicResearch/2022/9/19/will-higher-interest-rates-tame-inflation
Re "Wesbury's comments regarding abundant reserves vs scarce reserves model." Brian has a valid point when he stresses that the Fed has never used this model to bring down inflation before, and therefore we can't be sure it will work.
I think the abundant reserves model has one virtue, since it avoids having to create a scarcity of liquidity in the banking system, and all the unintended consequences a shortage of liquidity can lead to. But it has another problem as well, since, as is the case now, a substantial hike in short-term interest rates can put the Fed in the awkward position of having to pay out more in interest on reserves than it earns in coupons on its security holdings. While this doesn't yet pose a serious problem, it is obviously not sustainable for long.
Whatever the case, I observe that there are abundant signs that the demand for money now exceeds the supply of it, with the result that inflation pressures are declining. The Fed has done enough for now and should—and I think they soon will—begin to back off on their tightening stance. I have also argued that the inflation problem we have was not the result of a negligent Fed, but instead the result of a reckless surge in deficit-funded transfer payments to the working population. In short, our inflation problem today is the result of bad fiscal policy, not bad monetary policy. Fortunately, the bad fiscal policy has faded in importance and is unlikely to repeat. The economy has begun to digest the surplus money problem and a return to relative price stability appears within reach without requiring the Fed to torture the economy into a recession.
Is the economics "profession" so lacking in talent that there isn't any ability to do economic modeling? When I was in school many decades ago, predictive "econometric" modeling was all the rage. Did they stop doing that?
The performance of the Fed chairs over the past ~25 years relative to predicting inflation, dysfunction in various markets, e.g. financial, real estate, is so poor, you wonder what they are doing.
By now they ought to be expressing the outputs of their predictive models, kind of like the hurricane trackers, or biological, environmental, and other modelers. They can state the predicted values, uncertainty levels, etc.
Some of the empirical people I follow (many with engineering backgrounds), do better than these supposed "professional experts".
It is really not acceptable to be paying for these university and government economists if this is all they can do.
From the First Trust reference:
"Technically, banks can do whatever they want with these
reserves as long as they meet the capital and liquidity ratio
requirements set by regulators. They can hold them at the Fed
and get the interest rate the Fed sets, or they can lend them out at
current market interest rates. In turn, the big question is whether
the Fed can pay banks enough to stop them from lending in the
private marketplace and multiplying the money supply."
Before discussing the conclusions and the implications, it's important to look at the underlying assumptions, some of which are misleading or simply incorrect.
Reserves are printed in the Fed-banks financial plumbing and cannot leave the system unless the Fed retires them. Banks can lend them among themselves (which used to make sense when reserves were scarce) but reserves cannot be lent out to private participants.
Banks can lend against capital (reserves can apply) and this creates a loan-deposit (asset-liability) in the private system but (again) reserves cannot leave the Fed-banks financial plumbing.
What's the point?
The Fed does not have to pay interest on reserves in order to keep them within the system.
Then why do they pay IOER now?
The Fed can delay or precipitate the day of reckoning (correcting unsustainable financial imbalances) and they now focus on the latter (not because of the day of reckoning thing (à la Volcker), because they are chasing inflation curves, the same way they will (try to) chase the recession curves later on; they are behind the curves and don't seem to appreciate that their operations work with a lag).
Because of the well established liquidity preference relationship (from Keynes and al etc) there is a non-linear relationship between short term interest rates and the amount of base money the Fed prints versus the underlying economy. They are now concerned that they are behind the inflation curve so they decided to raise the interest on excess reserves (acts as a floor). Now this is clearly having an effect if you are shopping for a house, a car etc (obviously, especially in our debt-addicted world). In order to bring short term interest rates where they are now, simply by shrinking the Fed balance sheet of SOMA securities, means selling a very significant and destabilizing amount (just think of 2019 when the environment was much more benign and when they were surprised that the world financial plumbing had gotten used to a wildly excessive reserve environment). By raising the interest they pay on reserves, they likely feel that this would allow them to gradually shrink their balance over a period of a few years but they painted themselves in a corner (you can check out anytime you like but you can never leave).
https://www.youtube.com/watch?v=UehilhnMt5Y
Yes the pivot is coming and we may never have to experience what is materializing as we discuss ie Fed balance sheet operating loss and negative equity.
Money flows, the volume and velocity of money, are decelerating. M*Vt has always bottomed at the same time the stock market bottoms - always.
Volcker never tried monetarism. In fact, Volcker discontinued monetarism via H.R.6267 - Garn-St. Germain Depository Institutions Act of 1982, e.g., the "low reserve tranche" and the "exemption amount".
"Exempts financial institutions with less than a specified amount of total deposits from the reserve requirements of the Monetary Control Act of 1980."
The FED's Ph.Ds. are clueless. Banks don't lend deposits; deposits are the result of lending.
Chairman Paul Volcker, in a 1982 WSJ article was quoted as saying that he “believes in principle the Fed should pay interest on reserves held against deposits on rounds of equity” and “as a matter of principle favors payment of interest on all reserve balances”.
Legal reserves were "Manna from Heaven". Prior to the payment of interest on interbank demand deposits, which emasculated the "money multiplier" (the truistic money multiplier excludes currency), the banks remained fully lent up between 1942 and 2008.
A brief “run down” will indicate just how costless, indeed how profitable – to the participants, was the creation of new money. If the Fed put through buy orders in the open market, the Federal Reserve Banks acquire earning assets by creating new inter-bank demand deposits (clearing balances).
The U.S. Treasury recaptures about 98% of the net income from these assets. The commercial banks acquire “free” legal reserves, yet the bankers protested that they didn't earn any interest on their balances in the Federal Reserve Banks.
Given bankable opportunities (and the Federal Government is the largest creditworthy borrower providing zero risk-weighted assets), on the basis of these newly acquired free reserves, the commercial banks created a multiple volume of credit and money. And, through this money, they acquired a concomitant volume of additional earnings assets.
How much was this multiple expansion of money, credit, and bank earning assets? Thanks to fractional reserve banking (an essential characteristic of commercial banking) for every dollar of legal reserves pumped into the member banks by the Fed, the banking system acquired about $206:1 (c. 2006), dollars in earning assets through credit creation.
Link: “Bank Reserves and Loans: The Fed Is Pushing on A String” - Charles Hugh Smith
https://talkmarkets.com/content/bank-reserves-and-loans-the-fed-is-pushing-on-a-string?post=64407
"We don't know, no one knows whether this process will lead to a recession or, if so, how significant that recession would be," Powell said
Link: Daniel L. Thornton, Vice President and Economic Adviser: Research Division, Federal Reserve Bank of St. Louis, Working Paper Series:
“Monetary Policy: Why Money Matters and Interest Rates Don’t”
Thornton: “the interest rate is the price of credit, not the price of money”
Using a price mechanism, pegging rates, to ration Fed credit is non-sense (“a price mechanism is a system by which the allocation of resources and distribution of goods and services are made on the basis of relative market price”).
The effect of current open market operations on interest rates is indirect, varies widely over time, and in magnitude. What the net expansion of money will be, as a consequence of a given change in policy rates, nobody knows until long after the fact. The consequence is a delayed, remote, and approximate control over the lending and money-creating capacity of the banking system.
re: "Is the economics "profession" so lacking in talent that there isn't any ability to do economic modeling?"
Spot on. As American Yale Professor Irving Fisher said: “Each of these five magnitudes is extremely definite, and their relation to the purchasing power of money is definitely expressed by an “equation of exchange.”
“In my opinion, the branch of economics which treats of these five regulators of purchasing power ought to be recognized and ultimately will be recognized as an EXACT SCIENCE, capable of precise formulation, demonstration, and statistical verification.”
Trump had the right idea - fire Jerome Powell. Contrary to Nobel Laureates Dr. Milton Friedman and Dr. Anna Schwartz’s "A Program for Monetary Stability": the distributed lag effects of monetary flows have been mathematical constants for > 100 years. Therefore, we have a modeling which gives an accurate economic trajectory.
Unfortunately, that modeling used required reserves. That's how I predicted both the flash crash in stocks on May 6th, 2010 and the flash crash in bonds on October 15th, 2014 (6 months in advance and within 1 day).
Scott,
Many thanks for the informative and educational blog. I have been an avid reader now for almost a decade, and can not tell you how much I have learned. Great work and thanks!
Questions:
1) Would you agree that the current inflationary environment has causes that are several and disparate?
2) What role if any do you "feel" the rise of cryptocurrency played and will play in stoking global demand for goods and services?
I’m in Argentina “researching” their triple digit inflation. So far it has resulted in the impoverishment of nearly everyone. But for foreigners it is the Hearst place on earth. Great wine for $3/btl. Meanwhile I note that today’s M2 report was more good news for the inflation outlook in the US. Zero growth of M2 continues!
*cheapest place on earth.
People keep talking about interest rates. Watch the money stock. M2 is stalling. But our "means-of-payment" money supply is rising. And the "demand for money" is falling. The FED's in trouble.
actually Powell has raised rates faster than at any time since Volcker, derivative bets could blow up based on dollar, its part of the game of euro weakness needed as they are going to collapse. At same time take Gold and oil down to hurt Russia
currency wars are afoot
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