A quick look at GDP and corporate profits—not bad!

Third quarter GDP growth and inflation were revised upwards by a modest amount, but it remains the case that the economy has proved surprisingly resilient in spite of the Covid woes, and inflation has definitely cooled off. Corporate profits have been amazingly strong, and PE ratios look reasonable. And despite relatively weak growth in jobs—which now show a net gain vs. pre-Covid levels of a mere 1%—the economy has managed net growth of 4.4%, with the result that labor productivity has been quite impressive. Businesses have managed to do more with fewer people while at the same time boosting after-tax profits by 20% since pre-Covid levels. 

Chart #1

Chart #1 shows the year over year growth of real GDP, which was 1.94% as of Q3/22. This is very close to the growth rates the economy experienced from 2010 thru 2019. The Covid growth gyrations are now in the past. The economy looks to be on track to growth at about a 2% annual rate—nothing spectacular, but not bad considering all the problems that still exist in the world and at home.

Chart #2

Pay close attention to Chart #2, since you're unlikely to see anything like it elsewhere. To begin with, it's plotted using a logarithmic y-axis, which means that straight lines are equivalent to constant rates of growth. The dotted green line represents the annual growth trend which started in 1966 and persisted through 2007: 3.1% per year. That is, over this 56-year period the economy managed to grow by an annualized rate of 3.1%. Sometimes by more, sometimes by less, but over time it always came back to this trend line. The dotted red line shows the growth trend in place since mid-2009: 2.2%. Something happened during the Great Financial Recession of 2008-09 to put a permanent damper on growth, and it's not just demographics—demographics don't change dramatically from one year to the next. Instead, I think it has a lot to do with 1) the explosion of transfer payments during the Great Recession (see Charts #2 and #3 in this post), and 2) the general expansion of government influence, plus higher tax and regulatory burdens which plagued the economy during this period. These all work like headwinds to slow the economy.

It's tempting to speculate that had the economy pursued a 3.1% growth path until now, then the economy would be 24% bigger today, and average incomes might be 24% higher in inflation-adjusted terms. That's a lot of money that, arguably, may have been left on the table!

Chart #3

Chart #3 shows the quarterly annualized rate of change in the GDP deflator. This is the broadest measure of inflation that exists. Inflation in the third quarter slowed dramatically (from 9.1% to 4.4%), and that is consistent with my observations in recent posts that the peak of inflation occurred sometime around the middle of this year. This is most reassuring, and I would like to think it won't escape the Fed's notice. 

Chart #4

Chart #4 shows the price/earnings ratio of the S&P 500, using trailing 12-month profits from continuing operations. The PE ratio of the market today is about 18.5, only slightly higher than its long-term average. 

Chart #5

Chart #5 shows PE ratios for the S&P 500 using the National Income and Product Accounts as the source for economy-wide, after-tax corporate profits instead of trailing reported earnings. Like the current PE ratio shown in Chart #4, PE ratios by this measure are 19.5, only slightly higher than their long-term average. The advantage of this method is that the measure of profits used is a quarterly-annualized number, not a trailing 12-month average—thus it's much more timely.

Chart #6

Chart #6 shows the same NIPA measure of profits as a percent of nominal GDP. What stands out here is the consistently high level of profits in the period following the Great Financial Recession, compared to what prevailed in prior decades. It's no wonder the stock market has been so strong this past decade or so—corporate profits have never been so consistently healthy. 

I think the main reason for this is globalization, which picked up speed some years after the opening of the Chinese economy in 1995. Successful corporations today can address the entire world market, whereas before most businesses were able to address only part of global market. Apple would be successful if it were restricted to just the US market, but today it can leverage its successful products by many times since its market is an order of magnitude larger today than it would have been 15-20 years ago. 

Higher interest rates have solved the inflation problem

As I've been pointing out for over two years, rapid growth in the M2 money supply is a big deal, and one that has not received much attention, if any. At first (i.e., mid- to late 2020) it was OK, because the public felt comfortable holding on to large amounts of cash in their bank deposit and savings accounts at a time of great Covid-related uncertainty and economy-wide lockdowns. But starting early last year, when the worst of the Covid panic was subsiding and life was beginning to get back to normal, people began spending that money. Soon, a flood of spending collided with supply shortages and a still-crippled economy, and the result was higher prices. By the end of last year, inflation was galloping towards 10% or so, but the Fed ignored it, asserting it was merely "transitory." It wasn't until March of this year that the Fed began to get worried. True to form (unfortunately), the Fed was—once again!—late to the inflation party, and they have been trying to catch up ever since. As we now know, they embarked on an impressive series of rate hikes which took short-term rates from 0.25% last March to now 4.5%. That marked the most aggressive monetary tightening in history.

Last week the Fed reiterated its intention to snuff out inflation with still more hikes. Sadly, they are now overstaying their welcome at the inflation party, because we know that inflation peaked many months ago. Unfortunately they didn't get my memo on the subject.

The market is rightly concerned to be worried by all of this.

When all is said and done, the Fed has but one job: to keep the demand for money in line with the supply of money. When the supply of money exceeds the demand for it, inflation is the result, as Milton Friedman taught us long ago and which the experience of the past several years shows us. (I should add that, according to their official mandate, the Fed is also charged with maintaining full employment, but we'll put that aside, especially since they now hint that they won't feel comfortable until they see the economy weaken significantly.) 

Beginning early last year, the demand for money fell even as the supply of money (best measured by M2) continued to rise. It's no wonder that inflation rose. In fact, rising inflation confirmed that the demand for money was failing to keep pace with the supply of money. But beginning about 6-8 months ago, when (not coincidentally) the Fed started to raise interest rates, inflation started to decline. This, we know now, was early evidence that the demand for money stopped falling, while at the same time the M2 money supply started shrinking. My recommendation to the Fed, therefore, has been to give the economy time to adjust—they had done plenty enough.

Over the past six months or so, it has become quite clear that higher interest rates have served to bolster the demand for money. No longer are people trying to aggressively spend down their bank balances, because now they can earn a decent rate of interest on their cash. Put another way, the Fed has raised interest rates by enough to once again bring money supply and demand back into balance. It's also the case that supply chain problems have all but dried up. We know all of this because sensitive prices (e.g., housing prices, commodity prices, the value of the dollar and the price of gold) have fallen. Money demand looks to be much more closely aligned with money supply these days.

In the housing market it's beginning to look like interest rates are too high, in fact, as the following charts illustrate. 

Economics is all about scarcity and incentives. Higher interest rates give people an incentive to hold on to cash rather than spend it, and they give people less incentive to buy and hold on to things like housing. To judge from falling home prices and collapsing home sales and residential construction, higher interest rates have REALLY had a significant impact on the demand for money. Any higher and we'll have a recession on our hands—and that is exactly what worries the equity market these days.

Chart #1

Chart #1 compares the level of housing starts (blue line) with an index of homebuilders' sentiment. Not surprisingly, sentiment tends to precede starts. The more optimistic builders are about the housing market, the more likely they are to embark on new construction. The recent collapse of sentiment thus portends a dramatic decline in housing starts.

Chart #2

Chart #2 shows the number of residential building permits, which recently have begun to decline markedly as Chart #1 predicted. Look for further weakness in all these numbers. 

Chart #3

Chart # shows the number of single family home sales, which have collapsed in recent months. A plunge in sales is one of the reasons homebuilders are much less optimistic. 

Chart #4

Chart #4 shows an index of the number of new mortgage applications (first-time buyers seeking a mortgage to purchase a home). This also has plunged, down by over 40% so far this year.

Chart #5

Chart #5 shows the reason why all this is happening: 30-yr fixed mortgage rates have more than doubled in the past year. Never before has a shock of this magnitude occurred in the housing market. Higher mortgage rates on top of rising home prices have increased the cost of home ownership by an order of magnitude. And why have rates soared? Because the Fed has jacked up interest rates by several orders of magnitude and this has pushed up interest rates across the yield curve. Soaring interest rates have crushed the bond market and this in turn has led to many investors scrambling to hedge themselves against further rate hikes. No one wants to own 30-yr mortgage paper if rates rise further, because that means refinancings will grind to a halt and that paper will acquire a significant amount of duration risk: the value of a fixed rate mortgage will decline by more than about 10% for every 1 percentage point increase in mortgage rates.

As a result, the spread between mortgage rates and 10-yr Treasury yields has widened to just about its widest point ever, over 300 bps. Everything is working against the housing market. 

Does the Fed really want to crush the housing market by hiking rates further? I think they will come to their senses pretty quickly and back off of their recently-announced tightening pledge. The demand for money is soaring and that means inflation will continue to decline. Nobody needs higher rates right now.

PPI inflation plunges

Sometimes the headlines are just plain wrong. Here's an example.

Bloomberg headline this morning: "US Producer Prices Top Estimates, Supporting Fed Hikes Into 2023"

How do they reach this conclusion? By observing that "the PPI for final demand climbed 0.3% for a third month," when market expectations called for only a 0.2% rise in November. Huh? The monthly change in this index was 0.01% higher than expected, and you think that is a reason for the Fed to raise rates further?

I see it quite differently, as these charts show:

Chart #1

Chart #2

Chart #3

No matter how you look at the data, these charts lead you to an inescapable conclusion: Inflation at the wholesale level peaked in June of this year, and since then it has virtually plunged. 

The message this sends to the Fed is clear: there is no reason to raise rates further. Stop the hikes. Whatever you've done so far is definitely working. Don't overdo it!

About that yield curve inversion ...

Conventional wisdom says that an inversion of the Treasury yield curve is a good predictor of a forthcoming recession. Today the yield curve is more inverted than at any time since the early 1980s, so many are saying that means the chances of a recession are pretty high. The curve is strongly inverted because the bond market figures that a recession will force the Fed to reduce short-term rates in the future, but not immediately—in fact the market expects at least one more tightening of 50 bps and possibly another within 4-5 months.

I've discussed this subject many times here on this blog, and I've tried to make the point that while an inverted yield curve has indeed preceded every recession, so have other indicators: e.g., very high real yields, high swap and credit spreads, and rising unemployment claims. None of those other indicators are flashing recession signals right now. Plus, the current Fed tightening cycle is very different this time than at any other time before. The Fed no longer drains liquidity in order to push short-term rates higher, and that means a lot less pressure on the banking system. Liquidity today is in fact still abundant.

I've also pointed out that the inflation problem we're experiencing today is unique: unlike all other tightening cycles (nearly every one of which preceded a recession), the Fed was fighting an inflation that the Fed itself caused (i.e., by being too easy for too long). This time around, the inflation was the result of massive government spending (transfer payments) that came at a time when the economy was in lockdown and risk aversion was very high. People welcomed the cash and let it sit in their bank accounts. But starting early last year the cash wasn't so welcome or needed, so people started spending at a time when the economy wasn't ready to meet the demand, and inflation was the result. So the inflation problem this time is more temporary in nature, and thus should be easier to resolve. And in fact it is being resolved as we speak: witness the strong dollar, falling commodity prices, falling housing and commercial property prices, and the fact that most measures of inflation peaked some months ago.

Add it all up and I think the odds of a recession are lower than the market is priced for, which implies that the Fed is likely to hike rates less than the market expects.

Some charts to illustrate:

Chart #1

Chart #1 shows the slope of the Treasury yield curve (red line) and the real Fed funds rate (blue line). Note that an inverted curve and high real rates have always preceded recessions. Yes, today the curve is very inverted, but real yields are not particularly high. High real yields crush debtors, but that's not the case today.  Note how low credit spreads are in the next two charts.

Chart #2

Chart #2 shows the level of 2-yr swap spreads. When low, these spreads suggest that the outlook for the economy and corporate profit is good, and liquidity conditions are plentiful. Spreads today have been this high many times without a recession following.

Chart #3

Chart #3 shows credit spreads for investment grade and high-yield corporate bonds. Low spreads suggest the market is relatively confident about the outlook for corporate profits and that in turn implies the outlook for the economy is healthy. Although they are somewhat elevated, they are nowhere near the levels we see prior to or during recessions. 

The huge problem of transfer payments

History will record that public policy in the Covid era was extraordinarily bad. Lockdowns, school closures and mask mandates were not only ineffective, they exacted a huge toll in overall health, human suffering, learning loss, and economic damage. As we now know, Sweden, virtually the only country to eschew these policies, experienced the lowest excess mortality rate in the world and the healthiest economy.

Back in April/May of 2020 I predicted that "the shutdown of the US economy would prove to be the most expensive self-inflicted injury in the history of mankind." I believe I have been fully vindicated on that score.

In an attempt to mitigate the economic damage of these policies, many countries resorted to massive transfer payments designed to make up for job and earnings losses, and to shore up their economies. The U.S. was arguably the leader among nations in this regard. Sadly, as the dust settles we now see that massive transfer payments were the direct cause of the biggest surge in inflation since the inflationary 1970s.

As if that weren't bad enough, transfer payments (money people receive from the government for which no goods or services are exchanged; e.g., social security, unemployment insurance, stimulus payments) have seriously reduced the incentives to work, leaving the U.S. economy with a shortage of labor and an anemic economy. The Fed can't fix that—only Congress can. 

Chart #1

Federal transfer payments are now running at about a $4 trillion annual rate. Chart #1 shows transfer payments as a percent of disposable income. Over 20% of the disposable income in the U.S. now comes in the form of payments to individuals who don't have to work for it. By this measure, transfer payments have more than quadrupled since the early 1950s, and they show no signs of shrinking. 

Charts #2 and #3

Chart #2 zooms in on the percent of disposable income derived from transfer payments since 1970. Chart #3 is plotted with the same x-axis, and it shows the labor force participation rate (i.e., the percent of the population of working age that is either working or looking for work). The dashed lines strongly suggest that the big decline in the labor force participation rate since 2008 had a lot to do with a huge increase in transfer payments. Not surprisingly, paying people to not work does not encourage them to work.

If we want to restore the economy's former vigor, we need to reduce transfer payments and increase the incentives to work and invest. We need to incentivize people to work by reducing tax and regulatory burdens. 

Chart #4

I've featured Chart #4 several times in the past 6 months or so. It is designed to show that the huge and unprecedented increase in the M2 money supply was the direct result of massive increases in the federal deficit. The government "borrowed" some $5-6 trillion in order to send out a blizzard of checks to individuals. Most of that money ended up sitting in bank savings and deposit accounts (the main source of M2 growth) because a) people didn't have an opportunity to spend it, given the lockdowns, and b) the huge degree of uncertainty and fear which dominated the Covid era made nearly everyone acutely risk-averse. Trillions of dollars were stockpiled in the nation's banks as a result, and now that people don't want or need all that money it is getting spent, and that is fueling the rise in prices. 

Fortunately, the source of this national inflation nightmare is fading. The federal deficit is reverting to trend, and there doesn't appear to be a Congressional appetite for yet another round of "stimulus" checks. 

Chart #5

Chart #5 compares the year over year growth of M2 to the growth of the CPI. The CPI line is shifted one year to the left, in recognition of the fact that a) there are lags between monetary policy and its effects on inflation, and b) it took about a year from the time the first round of stimulus checks boosted the money supply until the time the Covid scare had passed and people started spending money in earnest. The chart suggests that it will take at least a year before inflation subsides to a level we're all more comfortable with. From what I can see, we are on track to a lower inflation future. 

What we've learned from all of this:

The proximate cause of our inflation problem was a huge increase in federal transfer payments that ended up being monetized, most of it at a time when people no longer wanted to hold so much cash. The economy couldn't absorb all that extra spending (think supply-chain bottlenecks and labor shortages), so unwanted cash ended up fueling inflation. That source of inflation is no longer operative, since transfer payments have reverted to trend. The excess amount of M2 is being worked off as people spend money and the economy grows (in both real and nominal terms). Chart #3 in this post illustrates the process. 

The most important thing the Fed can do today is what they have been doing: raise interest rates. Higher interest rates serve to increase the demand for all the excess money still sitting in bank deposits. Inflation happened because the demand for those deposits fell (because people preferred to spend their money rather than hold on to it) as the Covid scare faded. Without higher interest rates, people would be spending a lot more from their savings, and that would push inflation higher. With higher interest rates, savings and money market accounts have become much more attractive, and people are willing to hold on to the extra money, and that is allowing inflation to cool.

Memo to Fed: don't overdo the tightening. Inflation is receding, but it will take time to get back to 2%.

Memo to Congress: please stop spending money you don't have. It doesn't help the economy and it only threatens to keep inflation from falling.

UPDATE (12/20/22): Don't miss this article by my good friend Steve Moore: "It pays not to work in Biden's America—and here's the proof" Steve, Casey Mulligan and E. J. Antoni have documented astounding evidence that our welfare system pays too many people too much not to work. It fits perfectly with this post. 

Lower interest rates to the rescue

A few days ago, Chairman Powell essentially admitted that the Fed will no longer be pursuing an aggressive tightening policy. Since then, key interest rates have registered some significant declines, and that is good news for the housing market, the economy in general, and the stock market. We have probably seen the end of the shortest and most dramatic round of Fed tightening in history.

The Fed was late to see the inflation problem, which is very unfortunate, but they have not hesitated to act forcefully, and it seems to have worked. As almost always happens in the end stages of a Fed tightening, real yields have soared (up almost 400 bps in less than one year), the yield curve has inverted, the dollar has surged, commodity prices have dropped, the housing market has run into a brick wall, the stock market has sunk, and the economy appears set to enter a recession. All, of course, classic signs of very tight monetary conditions—tight enough to bring inflation down, and that is indeed what's happening.

There are some unique features to this tightening cycle which bear attention. Most importantly, there is no liquidity shortage. Liquidity is the lifeblood of the bond and stock markets, because liquidity means that people can easily and quickly trade their positions and adjust their exposure to risk. We all know what happens when someone yells "Fire!" in a crowded theater: panic sets in and the exits quickly jam—casualties occur. But with plentiful liquidity, it's like being in a crowded open-air theater when someone yells fire—you simply walk outside unimpeded. And so it is today; there are few if any signs of the distress that typically accompanies very tight money. Credit spreads are low, especially the all-important swap spreads, which are a gauge of how easy it is for people to buy and sell all kinds of securities and risks in size (see Chart #1 in this post for a history of swap spreads). Credit default spreads are low. Volatility is subsiding. There has been a surge of layoffs, but they are mostly concentrated in tech companies that had become seriously bloated. Unemployment claims are low and job growth has exceeded expectations; in fact, there are more job openings than there are people willing to work. 

Another key difference this time around is that the bout of inflation we have suffered was not the result of Fed policy (it is usually is). It was the result of a massive surge in Covid "stimulus" payments which put trillions of dollars into the hands of people who were still hunkered down and unable to spend it. The result was a multi-trillion dollar surge in bank savings and deposit accounts. Once the Covid scare passed, the liquidity dam broke and a tsunami of price increases spread throughout the economy. 

So it wasn't low interest rates that caused the problem, it was too much government spending. Higher interest rates came to the rescue, giving people and incentive to hold on to their extra cash, and that minimized the spending tsunami. Now, interest rates can decline and help the economy get back on a normal track fairly easily. It won't all happen at once, but the wheels have been set in motion. Meanwhile, M2 is declining, which means that excess cash is being reduced with the passage of time.

Chart #1

Chart #1 shows the level of real yields on 5-yr TIPS. In the past year they have surged from -2% to almost +2%. That's an unprecedented swing of almost 400 bps in a relatively short time frame. That's why this year proved to be the most painful in history for anyone exposed to higher interest rates. Fortunately we appear to be waking up from this nightmare.

Chart #2

Chart #2 shows the national average rate on 30-yr fixed-rate mortgages. This has dropped from a high of 7.3% to now 6.5%: a decline of almost 80 bps in less than two months. This is the first step in making homes more affordable, but it won't be the last. Rates are going to have to decline significantly, and they should, even if 10-yr Treasury yields don't fall further. Chart #3 explains why.

Chart #3

Chart #3 shows 30-yr mortgage rates (white line in the top half of the chart), 10-yr Treasury yields (orange line), and the spread between in the two in the bottom half of the chart. 10-yr Treasury yields are the benchmark for mortgage rates; mortgage rates typically run about 150 basis points above the 10-yr Treasury yield. In recent months, however, the spread ballooned to over 300 bps—twice the normal spread. If 10-yr Treasury yields stabilize around 3.5%, 30-yr mortgage rates should eventually decline to about 5%

Chart #4

Chart #4 shows Credit Default Swap spreads, which reflect the market's assessment of the health of the economy and corporate profits. Spreads are still somewhat elevated, but they have declined impressively in the past few months. This is not what you would expect to see if the economy, as many seem to believe, were on the cusp of a recession. 

While we're on the subject of market fears, it's timely to look at the burden of our surging federal debt, which has now reached $24.6 trillion. You have probably seen many analysts saying it is $34.1 trillion, but that includes $6.9 trillion of intragovernmental holdings which is just an accounting fiction: money that one part of the government owes another. What counts is the debt that our government owes to the public.

$24.6 trillion is still an immense amount of debt. Relative to GDP, our national debt, now about 95% of GDP, was only once higher, at the tail end of World War II. Back then it got to almost 125% of GDP, but the world didn't end. In fact, after WWII, our debt/GDP ratio plunged as the economy boomed. It might seem improbable, but there is no a priori reason it can't happen again.

Chart #5

Furthermore, it is not inevitable that all this debt will push interest rates higher, thus imposing an impossible burden of debt service as many fear mongers are arguing. As Chart #5 shows, it would appear that a rising debt/GDP ratio can occur with lower interest rates, not higher. And a falling debt/GDP ratio can even correspond to higher interest rates.

Chart #6

Chart #6 shows the burden of our national debt, which is the cost of servicing the debt as a percentage of GDP. I've estimated what it will be by the end of this year. And as you can see, it will still be very low from an historical perspective because interest rates are still relatively low. If interest rates stabilize or decline from current levels, and the economy remains reasonably healthy, the debt burden is unlikely to reach unprecedented levels. 

It all depends on how the economy behaves—how much inflation we have and how much growth. Higher inflation shrinks the burden of debt, because it can be paid back with cheaper dollars. A stronger economy boosts tax revenues, which helps support debt repayment. And in any event, paying back the debt is not equivalent to flushing money down the toilet. Every dollar of interest paid on our debt goes into someone's pocket. It doesn't disappear from the economy.

What's bad about our national debt is not the amount of debt that must be serviced, it's what was done with the money we borrowed. Therein lies the real burden of debt. If the money borrowed is squandered, then that places a huge burden on an economy that has not become more productive or more efficient. Unfortunately, a huge portion of our current debt (about $5-6 trillion) was money that was borrowed—or printed—and then handed out to the public. Using debt to finance spending is terrible, since it doesn't enhance the economy's productivity. We essentially wasted $5-6 trillion that might have been better spent on investments that create jobs. The real burden of that debt will thus be paid by future generations, in the form of a slower-than-average rise in living standards. 

The Fed pivots—finally!

Thanks to today's release of the November 2nd FOMC meeting minutes, we know that the Fed has "pivoted" as expected; they are backing off of their aggressive tightening agenda. Instead of hiking rates another 75 bps at their December 14th meeting, we are likely to see only a 50 bps hike, to 4.5%, and that could well be the last hike of this tightening cycle—which would make it the shortest tightening cycle on record (less than one year). And they might not even raise rates at all in December—that would be my preference.

For more than two years I have been one of a handful of economists keeping an eye on the rapid growth of the M2 money supply. Initially I warned that it portended much higher inflation than the market was expecting. But since May of this year I have argued that inflation pressures have peaked: "Many factors have contributed to this: growth in the M2 money supply has been essentially zero since late last year; the stimulus checks have ceased; the dollar has been very strong; commodity prices have been very weak; and soaring interest rates have brought the housing market to its knees. All of these developments mean that the supply of money and the demand to hold it have come back to some semblance of balance." To sum it up, I think the Fed has gotten policy back on track, so there's no need to do more. In fact, the October M2 release showed even more of a slowdown than previously, thus underscoring the need to avoid further tightening.

For a recap of my thinking on all this, here is a short summary of relevant posts:

October '20: On the demand for money and other considerations

March '21: The problem with unwanted money and More signs that inflation is set to increase

July '21: Big changes in inflation and government finances

August '21: Inflation update: this is serious

September '21: Money and inflation update

October '21: Monetary policy is a slow-motion train wreck

November '21: Recession risk is very low, but inflation risk is high

January '22: The bond market is wrong about inflation

Beginning last May I began arguing that we had seen the peak of inflation pressures, thanks to a big decline in the growth of the M2 money supply.

May '22: M2 growth slows: light at the end of the inflation...

August '22: Inflation pressures cool, economic outlook improves

Sep '22: Inflation pressures are in fact cooling ...

I'm still firmly in the inflation-is-falling camp, and it's because of the unprecedented decline in the M2 money supply, coupled with forceful actions on the part of the Fed to bolster money demand with sharply higher interest rates. As a result, I believe we are going to see a gradual decline in inflation over the next year or so.

The following charts round out the story:

Chart #1

Chart #1 has got to be the most significant monetary development that almost no one is paying attention to. It shows how M2 surged above its long-term trend growth rate beginning in April 2020, and then stopped growing about one year ago. It is still quite elevated (i.e., there is a lot of "excess" money sloshing around), but the growth rate of M2 is now negative: over the past six months M2 is down at an annualized rate of -2%, and over the past 3 months it is down at a -4% annualized rate. This adds up to the weakest growth of M2 since at least 1960—and possibly the weakest growth ever. M2 today is about 22% above its long-term trend, whereas it was almost 30% above trend earlier this year. The amount of "excess" money is declining rapidly, and that is a good thing.

Chart #2

Chart #2 shows how the surge in M2 growth was almost entirely driven by massive federal deficit spending from 2020 through late 2021. In effect, the government sent out many trillions in "stimulus" checks to people and most of that money ended up being stashed in bank deposit and savings accounts. The demand for money was intense back then since there was great pandemic-fueled uncertainty and besides, lockdowns left people with little ability to spend money. All that money wasn't a problem until early this year, when the pandemic crisis began to recede. That marked the point when people started to spend the money they had stockpiled, and that spending surge combined with supply-chain bottlenecks to produce a wave of higher prices for nearly everything. In short, an improving outlook and a return of confidence meant that the demand for all that money was evaporating.

Chart #3

Chart #3 tracks the demand for money as defined by the ratio of M2 to nominal GDP. Let me explain: M2 is a proxy for the amount of money the average person holds in currency and bank deposits. Nominal GDP is a proxy for average annual incomes. The ratio of the two therefore tells us what percent of one's annual salary is held in the form of readily-spendable money. When the ratio is higher than people feel comfortable with (i.e., when there is no longer a need to stockpile funds for a rainy day), people attempt to spend down their money balances, and that fuels a surge in demand. Money balances decline, and nominal GDP surges. I estimate that the ratio of M2 to GDP will fall to almost 80% by the end of this year, down from just over 90% at its peak in Q2/20. Today there is simply no need for people to hold so much of their income in the form of cash. Indeed, I don't see why this ratio can't fall back to 70%, where it was before the pandemic hit. For that to happen, nominal GDP (mostly inflation) is almost certainly going to continue to grow, albeit at a slower pace, and M2 balances are likely to decline some more.

(Note: for those who prefer to think in terms of the velocity of money, just invert Chart #3. Velocity is simply the inverse of money demand, and vice versa. Today velocity is definitely picking up. For a longer explanation of this see this post.)

As Milton Friedman taught us, inflation happens when the supply of money exceeds the demand for it. It's critical to understand that rapid growth in M2 from Q2/20 through Q3/21 was not inflationary because the demand for money was very strong during that period. But when the demand for money started to fall early this year, then inflation surged, even though M2 was no longer growing. From this we can infer that the demand for money fell significantly.

Money demand is likely still declining, and money supply is still contracting, but the huge rise in interest rates this year has acted to bolster money demand: earning 4-5% on bank CDs is an incentive to hold on to that money you stashed in the bank—at least some it. The net result of all this is an easing of inflationary pressures. That can be seen already in falling commodity prices and housing prices.

Chart #4

Chart #4 shows the level of bank reserves held by US banks. Recall that bank reserves are not money that can be spent anywhere. They are assets of the banking system and liabilities of the Fed; their main role today is to collateralize deposits and provide abundant risk-free assets to the banking system, since bank reserves are essentially default-free. Reserves are still super-abundant, thanks to the Fed's decision in late 2008 to permanently expand the level of bank reserves while controlling interest rates directly (i.e, by paying interest on reserves). In prior tightening cycles, the Fed had to drain reserves in order to force interest rates higher; that put a real squeeze on financial markets since it reduced liquidity. Now the Fed simply pays a higher rate on reserves instead of shrinking their supply, so the system is spared a liquidity crunch.

Chart #5

Chart #5 shows option-adjusted credit spreads for corporate bonds. This is an excellent proxy for the level of economic and financial stress in the US economy. As we see, despite a massive amount of monetary tightening, spreads are still at relatively low levels. In prior tightening episodes, spreads surged and bankruptcies followed, because the Fed was restricting liquidity. This time around things are very different. The risk of a recession is therefore much lower in today's monetary environment. Another great indicator of financial and economic stress is 2-yr swap spreads, and today they are a mere 31 bps, well within the range of normal.

Chart #6

Chart #6 shows us that household financial burdens (financial-related payments as a percent of disposable income) are unusually low. They were much higher going into recessions in the past. Businesses and households are still in pretty good shape despite all the tightening. Thus a recession is less likely now than during prior tightening cycles.

Shall we call this "tightening lite?"

Near-term Fed pivot almost guaranteed

The release this morning of October Producer Price indices brings yet more evidence that the inflationary pressures sparked by multi-trillion dollar Covid "stimulus" checks in 2020 and 2021 peaked earlier this year, as I have been pointing out for months. Many factors have contributed to this: growth in the M2 money supply has been essentially zero since late last year; the stimulus checks have ceased; the dollar has been very strong; commodity prices have been very weak; and soaring interest rates have brought the housing market to its knees. All of these developments mean that the supply of money and the demand to hold it have come back to some semblance of balance, and that is of course essential if inflation is to return to a low and steady rate of, say, 2%.

This all but guarantees that the Fed soon will be scaling back on its tightening agenda. For my money, the FOMC's November 2 rate hike (from 3.25% to 4.0%) should be the last, but a hike next month of 50 bps (to 4.5%) is likely to be the Fed's last move for the foreseeable future. The Fed simply can't react as fast as the market does to changing realities—unfortunately, the Fed is usually "behind the curve." In any event, a 4.5% funds rate by year end is fully priced into the market and thus it should not be very impactful. What will change though is the market's expectation for where rates will be a year from now: lower than currently expected, and that is what is driving equity prices higher. 

What's most important is that the market is now beginning to see across the valley of uncertainty to a time when inflation comes back down to 2%. It may take up to a year for that to happen, however, but as long as we know that the worst is over, markets can anticipate a lower-inflation future and equity markets can drift higher. And although it's very good news that inflation has peaked and is now declining, the bad news is that thanks to the 2020-2021 explosion of M2, the general price level will have suffered a major increase that is unlikely to be reversed. Real incomes have suffered and it will take a long time for them to recover.

Chart #1

Chart #1 shows the year over year changes in the total and core (ex-food and energy) versions of the Producer Price index. Both peaked about six months ago, and that was about six months after M2 stopped growing. 

Chart #2

Chart #2 shows the 6-mo. annualized change in the total and core versions of the PPI; this highlights the degree of change that has occurred in the past six months. 

Chart #3

Chart #3 shows the year over year and 6-mo. annualized changes in the final demand version of the PPI (a version which began in 2009). Here the change is even more dramatic. Overall, these three charts tell a story of a rapid deceleration in the growth of prices in the early stages of the supply chain. These changes are likely to be reflected in the months to come in a moderation of the growth of the CPI. 

Chart #4

Chart #4 shows the ex-energy version of the CPI index (plotted on a log scale so that changes in growth rates can be more easily visible). This version of the CPI (which I think is best because it eliminates the extreme volatility of energy prices) has been growing at about 2% per year for a long time. After March 2021 it suddenly picked up to a 7% rate of growth. It is likely to continue to grow faster than the former 2% annual trend for perhaps the next 12-15 months even as the year over year growth rate declines. I'm guessing that when the CPI returns to a 2% annual growth rate, the index will be at least 10-12% higher than the original 2% trend, and that would be about 20% above the level of March '21. Meaning, of course, that the price level will have experienced a one-time increase of at least 10% on top of its typical 2% annual rise. 

Inflation will be with us for some time to come, but its rate of increase will continue to moderate. This doesn't mean the Fed has to continue to tighten, however. Just maintaining its current stance would probably be sufficient to get inflation back down to 2%. That assumes, however, that M2 growth continues to be essentially flat and the government avoids sending out another massive batch of checks funded with the printing press. 

Fed fever is cooling off

I'd like to think that last week's post got the ball rolling, because the impulse for the 5.6% rally in the S&P 500 over the past three days looks to be declining expectations for Fed tightening. I thought it was inevitable: a super-strong dollar, collapsing housing and commodity prices, and a huge increase in real interest rates were all but shouting at the Fed to back off and give the economy some time to digest things.

The following charts highlight three major news items revealed today:

Chart #1

As I've been noting for well over a year, Chart #1 (growth of the M2 money supply) is the most important financial news that nobody (outside of a handful of economists) has been paying any attention to. As the chart shows, there was explosive growth (completely unprecedented!) in the money supply in 2020, driven almost entirely by the monetization of Covid stimulus payments in 2020-2021. This was the proximate cause of the inflation which has wracked the country for almost two years. Fortunately, with the cessation of Covid payments in mid-2021, M2 growth cooled dramatically: M2 has not increased meaningfully for the past 9 months, and it has in fact declined at a 2.2% annualized rate over the past 6 months, as we learned from this morning's release of the September numbers. This all but guarantees a future decline in measured inflation. 

If the Fed had been paying attention to the slowdown in M2, they would have toned down their tightening 4-5 months ago. And of course, if they had been paying attention to M2 18 months ago, they would have begun raising rates long before it became painfully obvious that we had an inflation problem. 

Chart #2

Chart #2 compares the value of the dollar (white line) with the level of real interest rates on 5-yr TIPS. Long-time readers will know that 5-yr real yields are the market's expectation for what the real Fed funds rate will average over the next 5 years, and as such they are the best measure to watch for how much the Fed is expected to tighten. These two variables have been joined at the hip for at least the past year: rising real rates have tracked the increase in the dollar's value on the forex markets. Declining real yields this month have closely tracked the decline in the dollar's value. A weaker dollar has nearly everyone breathing a sigh of relief. Maybe the Fed won't have to cause a recession after all ... as I argued in a post last August.

Chart #3

The other big piece of news this morning was the sharp decline in national home prices (Chart #3 shows the 12- and 6-month rates of growth of prices). It's important to note that the August number is actually an average of prices over the 3 months ending in August, which means that prices today are almost certainly much lower than the chart suggests. This decline in prices was virtually assured, given the doubling of 30-yr mortgage rates this year and the huge decline in new mortgage originations that I highlighted last week (Chart #3 of this post). The last thing the Fed needs to do is kill the housing market yet again (remember 2008?).

The next FOMC meeting is scheduled for November 2nd, and it's going to be very important. Not too long ago the market thought a 75 bps hike in the funds rate (to 4.25%) following that meeting was virtually assured. Now it's questionable, while a 50 bps hike is beginning to look like a (remote) possibility. 

China's dismal prospects

One-man rule can never compete with a free market, and that's very evident in the plunge in the value of Chinese companies. Xi Jinping, now fully in charge of China, may think he has reached the pinnacle of power, but the market is thinking he's doomed to defeat.

These two charts say it all:

Chart #1

Chart #1 compares the MSCI China Index (priced in Hong Kong dollars) to the S&P 500 index. By these measures, Chinese equities are cheaper now than they were in 1995, while US equities have increased by 176%. (The chart starts in 1995 because that is just after China massively devalued its currency and began opening its economy to the world.)

Chart #2

Chart #2 compares the Golden Dragon Index (Chinese companies that trade in the U.S.) to the S&P 500. The recent destruction in Chinese valuations shown in this chart is more evident: the Dragon Index today is down almost 80% from it's Feb. '21 high. 

One-man rule can never compete with a free market. 

Fed's Rx for the economy should be a tincture of time

As I've argued in recent posts, there's plenty of evidence to suggest the Fed has already tightened by enough to bring inflation down: the dollar is super-strong, real yields have risen sharply, the yield curve is inverted, commodity prices are plunging, and the housing market has run into a brick wall. Yet the Fed seems determined to tighten even more. I think they're driving by looking into the rear-view mirror. They're trying to burnish their reputation as an inflation fighter, after having fallen miserably behind the inflation curve in 2020 and 2021. And I think that the long-discredited Phillips Curve (which posits that unemployment must rise if inflation is to fall) still haunts the Fed governors' minds. It's all so unfortunate.

Fortunately, however, a recession is neither imminent nor inevitable. Industrial production and jobs are still growing at decent rates, 2-yr swap spreads are still in normal territory, and real interest rates are not prohibitively high. But the economy could fall into a recession if the Fed doesn't change course (aka "pivot") before too long. There's a precedent for this—in January 2019, when the Fed realized it had become too tight and reversed course—and I don't see why they can't do it again.

Chart #1

Chart #1 shows two measures of the inflation-adjusted and trade-weighted value of the dollar. By any measure the dollar is very strong. This is fully consistent with US monetary policy being tight and much tighter than that of any other major economy. Demand for dollars is strong, and there is no shortage of reasons for why that is so: geopolitical turmoil in Europe and East Asia would surely suffice. From an economics point of view, it would be highly unusual for a very strong currency to also be experiencing inflation (otherwise known as a loss of purchasing power). Prices all over the world, when translated into dollars, are falling.

Chart #2

Chart #2 compares the inflation-adjusted value of gold (red line) to the inverted value of the dollar (blue line). Big moves in the dollar's value almost always accompany inverse moves in commodity and gold prices. What's striking about today is that gold and commodity prices have not fallen further given the strength of the dollar. Long-time readers will note that this chart, which has appeared many times in recent years, has correctly predicted falling gold prices.

Chart #3

Chart #3 compares the nationwide average rate for 30-yr mortgages (orange line) to an index of new mortgage originations (mortgages taken on to finance the purchase of a new home). Mortgage rates have doubled this year, and new mortgage originations have fallen by half. That's a huge development! In other words, soaring mortgage rates combined with very high prices have dealt a heavy blow to the housing market. This is a perfect example of how higher interest rates can change incentives and also slow the economy. People today are much less willing to borrow (which implies higher money demand) and much less willing to buy (which also implies a demand for cash rather than goods. The sharply increased demand for money is acting directly to neutralize much of the extra M2 money supply that was created a few years ago. And that, in turn, means declining inflation pressures. (Recall that M2 has been flat for the past 9 months or so.)

Chart #4

Chart #4 compares housing starts (blue line) with an index of homebuilders' sentiment. Sentiment has plunged in recent months as homebuilders have seen a sudden slowdown in home purchases. In the past, sentiment has often been a very good predictor of housing starts. We could be on the verge of seeing a big slowdown in residential construction, and that would be a surefire contributor to a recession. Chairman Powell, please take note!

Chart #5

The top portion of Chart #5 compares the average rate on 30-yr mortgages (white line) with the yield on 10-yr Treasuries (orange line). The bottom portion shows the difference between the two, which looks to average about 150 bps in normal times. The spread today, in contrast, is over 300 bps; no wonder the housing market is in trouble. As the bottom chart also suggests, such peaks in spreads is typically short-lived, since they most likely reflect panicked selling and hedging by institutional players. Something is likely to change before too long, and it's likely that mortgage rates and spreads to Treasuries will decline.

Chart #6

Chart #6 compares the value of the dollar (orange line) with the real yield on 5-yr TIPS. As I've noted before, 5-yr real yields on TIPS are equivalent to the market's expectation for what the real Fed funds is going to average over the next 5 years. Real yields have soared by almost 400 bps in just over a year, which is not only unprecedented but also indicative of an extreme tightening of monetary policy. It's sort of like giving a horse tranquilizer to a mildly psychotic patient. Please, Chairman Powell, enough is enough!

Chart #7

Chart #7 compares an index of U.S. industrial production with a similar one in the Eurozone. Without a big decline in industrial production it is very unlikely that the U.S. economy is experiencing a recession. And so far, industrial production continues to grow. The Eurozone economy has been battered by the Ukraine conflict and soaring energy prices, yet industrial production has yet to decline. Both economies have an urge to recover what was lost to the Covid shutdowns.

Chart #8

Chart #8 shows the level of private sector non-farm employment, which continues to grow at a healthy pace. Recessions are famous for throwing people out of work, but we have yet to see any sign of that in the U.S. economy. 

Chart #9

Chart #9 shows the level of 2-yr swap spreads, my favorite indicator and predictor of the health of the U.S. economy and financial markets. Swap spreads are still within a "normal" range, which implies that liquidity is still abundant and the corporate profits and the economy are likely to remain reasonably healthy. As the chart suggests, swap spreads would have to rise appreciably before one might expect to see a recession on the horizon. Note also that swap spreads have tended to decline in advance of recoveries. 

Chart #10

Chart #10 is my favorite recession "dashboard," since it tracks two key indicators of monetary tightness and how they interact to produce recessions. Every recession here was preceded by an inversion of the yield curve (red line) and a significant rise in real short-term interest rates (blue line). As I noted in Chart #6, the market expects the Fed to raise short-term real interest rates (a key measure of Fed tightness) to at least 2% in coming years, but that has yet to happen, and so far the yield curve is only mildly inverted. To be fair, I'd score this chart as tentatively predicting a recession within the next year or so. 

Summing things up, there is little doubt that the Fed has already tightened monetary conditions to a significant degree. Sensitive prices (e.g., the dollar, commodity prices, gold) have turned down meaningfully, which alone would be a decent indicator of lower inflation to come. It would be a real shame if the Fed were to continue on its present tightening course in the belief that only by crippling the economy (e.g., higher unemployment, falling industrial production, and a collapsing housing market) can they hope to get inflation back under control. 

My recommendation would be for Dr. Powell to give the economy a "tincture of time," not higher interest rates.