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Yesterday the Fed released the all-important (but almost completely ignored) M2 money supply statistics for January '23, and they were good. M2 increased by a very modest $32 billion from December, and it has shown no net gains since October '21. Year over year M2 growth is -1.7%, and 6-mo annualized growth is -3.4%.
M2's huge growth from 2020 through 2021 provided the fuel for the inflation that has rocked the economy for the past year, and it's great news that it's fading away. The growth of M2, by over $6 trillion in two years, was the result of the monetization of roughly $6 trillion of Treasury debt issued to fund a tsunami of federal transfer payments in that same period. Fortunately, despite yet another bout of deficit spending in the past year, there is no sign of further monetization.
It is still mind-boggling to me that the unprecedented growth of M2 has almost completely escaped the public's notice. Most surprising of all: how in the world could the Fed not see it? Why was there only a handful of economists who commented on it, as I noted a year ago? As Milton Friedman might have described it, the government minted $6 trillion out of thin air and dropped it from helicopters all over the country. How could that not have resulted in higher prices?
In any event, here we are; the flood of funny money is receding. That's why there is now plenty of light at the end of the inflation tunnel.
Chart #1
Chart #1 is the main attraction. The M2 money supply exploded from $15.5 trillion in February '20 to $21.5 trillion in January '22. Since then, M2 growth has turned negative, and today M2 is only $3.4 trillion above where it might have been in the absence of the Fed's "helicopter drop." The gap is closing, and the money printing presses have been shut down. Inflation pressures peaked almost a year ago, and headline inflation will almost certainly continue to subside.
Chart #2
Chart #2 shows the 6-mo. annualized growth rate of M2, which is now -3.4%, down sharply from a high of over 40% in August of 2020. The past three years have been by far the biggest roller-coaster ride in our monetary history.
Chart #3
Chart #3 reveals the smoking gun in this story: Some $6 trillion of federal deficit-financed spending over a two-year period that was effectively monetized, showing up in the form of bank saving and deposit accounts (the major component of M2). At first this was fine, because the public was not willing or able to spend it—the demand for money was intense. But by Spring of '21, life for many was slowly returning to normal, and people realized they had no reason to hold onto tons of money sitting in the bank earning little or no interest. Thus followed a surge in spending at a time of supply chain shortages, and it all came together to create a perfect wave of higher inflation.
Chart #4
Chart #4 compares the growth of M2 with the year over year change in the CPI, which is shifted one year to the left in order to show that money growth leads inflation by about one year. This chart further suggests that the year over year change in the CPI will gradually fall to the Fed's 2% target over the course of this year, thanks to the huge deceleration in M2 growth over the past year.
Chart #5
Chart #5 shows the ratio of M2 to nominal GDP, a ratio I have called "money demand." Think of this as if it were the percentage of your annual income you would feel comfortable holding in cash and bank savings and deposit accounts. Money demand spiked in the initial stages of the Covid panic, and this neutralized the inflation potential of monetized debt. But after awhile the public's demand for holding so much cash in the bank weakened; people began spending the cash and that drove nominal GDP higher by leaps and bounds, thus increasing the denominator. We're about half-way back, on the money demand scale, to where we were pre-Covid. Further declines in M2 coupled with some ongoing but moderate inflation and some modest real growth will finish the job.
Chart #6
In the meantime, today's relatively high interest rates help offset the inflationary potential of the surplus M2 by increasing the incentive to hold on to money balances. Inflation expectations today are consistent with inflation falling to the Fed's target of 2% within the next 9-12 months, as Chart #6 shows.
The Fed doesn't need to do more than they already have. The lower-inflation wheels have been set in motion.
32 comments:
The FED changed the reporting of M2 from weekly to monthly. This was done in an effort to shift attention away from money supply growth.
Powell destroyed deposit classifications in May 2020 (eliminated the 6 withdrawal restrictions on savings accounts, which isolated money intended for spending, or means-of-payment money, from the money held as savings, or the demand for money (reciprocal of velocity).
"it seems that the modification of Regulation D in late April has effectively rendered savings accounts almost indistinguishable from checking accounts from the perspective of depositors and banks. Accordingly, the composition of M2 between M1 and non-M1 components conveys little economic information."
What's behind the recent surge in the M1 money supply?
https://fredblog.stlouisfed.org/2021/01/whats-behind-the-recent-surge-in-the-m1-money-supply/
Powell:
#1 “there was a time when monetary policy aggregates were important determinants of inflation and that has not been the case for a long time.”
#2 “Inflation is not a problem for this time as near as I can figure. Right now, M2 [money supply] does not really have important implications. It is something we have to unlearn.”
#3 “the correlation between different aggregates [like] M2 and inflation is just very, very low”.
The rate-of-change in currency in circulation is back to 2010 levels. The 6-month roc in our means-of-payment money has turned negative. When the 10-month roc turns negative there will be a recession. But now the FED won't know about it after a lag.
A cynic (who, me?) would note that the Fed shifted from weekly to monthly reporting for M2 on 2/11/21, which was almost exactly the time when money demand started to fall and inflation started to rise. It's almost as if the Fed wanted to bury the bad news before anyone noticed. My posts around that time were arguing strongly in favor of avoiding cash at all costs and buying just about anything because I thought inflation would surprise to the upside. My motto back then was "borrow and buy" and it was an excellent strategy.
So they deficit financed stimulus payments to the public bypassing the traditional fractional reserve banking system.
@Ataraxia
Deficit financing by the US government to pay the public, when the debt is sold to the public, does not result in an increase in money supply or M2.
Carl: you are right. Delicits that are financed by the sale of Treasuries shouldn’t increase the money supply. But this time, this one time only, that was the result. I don’t know of anyone who can detail exactly how this happened, unfortunately. It has baffled me for a long time.
^Ok Mr. Grannis, just pick any beginning and end dates for M2 change (at any time since early 2020 to now) and i'll try a little demonstration.
Is it possible that M2 was impacted by the sale of treasuries by foreign countries at the time?
Scott, when the Fed buys government bonds from the public in the open market couldn't that raise M2?
Great post.
Well, this gets complicated, but I think when the Fed buys US Treasuries (as opposed to selling to the public), it is essentially monetizing the debt, or engaging in money-financed fiscal program. Michael Woodford says this.
I understand it is usually commercial bank-lending that boosts the money-supply, but maybe we are in a new world.
And if you are not confused, then maybe you do not understand the situation.
The Fed needs to pause for few meeting and test the air. Middling inflation, slowing retreating, is not the end of the world. Why trigger a recession?
@Benjamin Cole - you wrote:
"The Fed needs to pause for few meeting and test the air."
If the Fed doesn't raise the Fed funds rate (target) at its next meeting then it will be going against market expectations and its own dot plot. To my mind that would represent a loosening of monetary policy - I don't believe that would be suitable.
Carl, Scott:
Isn't this how the money was created - as has been discussed so much here?:
- Treasury sells debt to public
- Banks buy debt from public, CREATING MONEY when they buy this debt (same as loans).
- Banks sell debt to Fed (for reserves)
i.e. in essence the Fed is financing this through bank money creation
Brent--
Well, you could be right. I guess one more 25-basis point hit would not crush the economy.
But there is more to life than a 2% inflation target.
The Reserve Bank of Australia has a 2% to 3% inflation target band. That seems better to me. The People's Bank of China shoots for "about" 3%.
2% may be too tight, and actually suffocate real growth. Getting to such a low rate quickly...is likely to trigger a recession.
Add on: We want people to support the free enterprise system. Unemployed people take a dim view of "free enterprise."
The error that has escaped the smartest guys in the room is that banks lend deposits. That's why interest rates were deregulated (by mistake). And then the FED began using interest rate manipulation in 1965 as its monetary transmission mechanism (by mistake). That's why legal reserves were eliminated (by mistake). Powell thinks banks are intermediaries [sic]
Monetary savings are activated via the nonbanks, which equates savings with investments (a velocity relationship). Contrariwise, bank-held savings are frozen, lost to both consumption and investment, indeed to any type of payment or expenditure. Banks pay for their earning assets with new money, not existing deposits.
Secular stagnation is a deceleration in the velocity of circulation, the impoundment of monetary savings.
Hi Scott, thank you for your valuable and timely content as always. Any comments on the continued up trend in the velocity of M2 and the potential for it to offset declining M2 levels? Also, it appears TIPs implied 1-yr and 2-yr inflation rates have moved up quite a bit recently after falling for several months. Any thoughts on this?
hu456h: As I see it, sharply higher interest rates are effectively slowing the uptrend in M2 velocity (i.e., slowing the decline in M2 demand) because higher rates encourage people to hold on to their money balances.
I rarely look at 1- and 2-yr implied inflation rates because they are subject to distortions of various sorts. The 5-yr implied rate is much more stable and reliable I think. While it has move up some, it is still comfortably in the range of where it's been for the past 2 years or so, and it is still consistent with a major decline in inflation on the horizon.
Well as expected it doesn't sound like Jay is going to take Scott's sage advice and sit on his hands. The Fed is almost always late-late to raise rates and probably late to stop raising them!
It is hard for the average person to believe that banks do not loan out savings or existing deposits – demand or time. But the DFIs always create money by making loans to, or buying securities from, the non-bank public.
This results in a double-bind for the Fed (FOMC schizophrenia: Do I stop because inflation is increasing? Or do I go because R-gDp is falling?). If it pursues a rather restrictive monetary policy, e.g., QT, interest rates tend to rise.
This places a damper on the creation of new money but, paradoxically drives existing money (savings) out of circulation into frozen deposits (un-used and un-spent). In a twinkling, the economy begins to suffer.
Hello Salmo,
So, because banks create money by buying securities from the non-bank public, is this not in fact where money is created (inflation - asset or otherwise) when the Fed does QE? I.e.:
- Fed buys securities from non bank market, but through banks, which in turn create money buying from the non bank public.
Why is it that Scott does not think this is printing money? Yes, Reserves are the new asset for the banks (for the liability of the printed money), and, yes, Reserves can be taken back by the Fed, but until they are, if they ever are, it is new money in the economy. The Fed is financing the Treasury, even if indirectly.
And as to the question of whether the Reserves can be turned into inside (real) money - yes they can. At any time the public can demand their "real" money (currency) by forcing the banks to turn the Reserves into said.
Carl, Scott, anyone please ...?
Scott
Wasn’t the money supply increased by 2.3 trillion more when the FED started buying MBS’s from the banks(assuming the banks only used 10% money base for the MBS’s)? And didn’t the banks money base increase by this amount allowing them to increase money supply by up to 23 trillion if they wanted? I’m confused is this part of M2?
Will
Will: Since 2008, the Fed has bought trillions of Treasuries and MBS. It paid for them with bank reserves, which are not part of M2. The Monetary Base, or M0, is equal to currency in circulation plus bank reserves. It used to be a meaningful statistic, but since 2008, with the Fed's adoption of a new monetary policy of allowing abundant reserves, the Monetary Base has changed so much that historical comparisons are meaningless. M2, the most widely-watched (and historically consistent) measure of the money supply, consists of currency in circulation plus various categories of bank savings and deposit accounts.
Bank reserves now total about $3 trillion, and theoretically that would be enough to support tens of trillions of dollars of bank deposits. But banks have not lent money willy-nilly, because a) they don't think there are enough credit worth borrowers, and/or b) there are not enough willing borrowers. In short, banks have the ability to lend a whole lot more, but they are not doing that.
Re: Powell's comments yesterday and today. I think Powell is making another mistake similar to the one he made in late 2018 when he wanted to hike interest rates more aggressively despite the absence of any signs that inflation was a problem; he worried that the economy was "too strong." This is the classic Phillips Curve knee-jerk reaction, and it is based on the incorrect belief that inflation happens when demand is "too strong." Powell is guilty of still believing in this discredited theory. But to his credit, he backed off on his tightening demands in early 2019 as it became obvious the market was concerned, and I think he will end up doing the same soon.
It is very unfortunate that the Powell completely ignored the enormous growth of M2 until rising inflation caught him by surprise. Now he seems desperate to re-establish his inflation-fighting bonafides. It's somewhat understandable I suppose, since he committed the most serious and costly monetary policy error this side of the inflationary 1970s.
"Will: Since 2008, the Fed has bought trillions of Treasuries and MBS. It paid for them with bank reserves, which are not part of M2."
This is an incomplete statement (and also misleading).
See page 4 of the following document:
https://economic-research.bnpparibas.com/pdf/en-US/Inside-money-creation-United-States-6/25/2021,43264
"However, when a commercial bank or the central bank purchases
government securities from a non-monetary entity (e.g., from a pension
fund), the value of the transaction is credited to the bank account of
that entity, resulting in an increase in the volume of deposits. Money
supply thus increases: the purchase of securities by the monetary
institution (money creation) offsets the effect of the initial subscription
to the securities by the pension fund (money destruction)11, whilst the
completion of the public spending results in additional deposits12."
Any thoughts on the YOY M2 going negative? What is the historical precedent on that? Haven't the previous 3-4 times M2 went negative YOY preceded some pretty ugly markets and economic environments? Like historically bad? 1870's, 18903, 1921, Great depression....
"But to his credit, he backed off on his tightening demands in early 2019 as it became obvious the market was concerned, and I think he will end up doing the same soon."
Interesting. The market didn't react. No plunge. So, do you mean he will first raise by 0.5 and then pause if the market goes down?
Roy, as a bond trader I totally agree with you. Stocks dropped 1.5% but that is almost an inured reaction while bonds haven't done much at all. Both markets seem to be waiting...
Steve,
I also think that inflation will go down by year-end, so with the Fed now over-tightening it increases the probability of recession (not seen in Grannis' data so far, so just speculation).
If you agree with this, would you say that now it's a good time to buy some < 2y treasuries?
Re "Any thoughts on the YOY M2 going negative?"
Most observers seem to be saying that negative YOY growth in M2 is a sure sign the economy is in trouble. There have indeed been episodes of negative M2 growth associated with economic weakness. But this time is VERY different, because M2 first grew by an explosive 40% or more: totally unprecedented in history. Even with negative growth over the past year, the cumulative increase in M2 since 2020 still leaves M2 far above its long-term trend. So I've been reading the M2 story as saying that before we had a huge overhang of M2 that was fueling inflation, and now we have less of an overhang, which is why inflation is cooling. Plus, now we have much higher interest rates which are giving people an incentive to hold on to all that extra M2 instead of trying to spend it.
Meanwhile, outside of obvious weakness in the housing market and a jump in corporate layoffs, it is hard to find signs of impending weakness or recession. Notably, swap and credit spreads are relatively low and declining—something that has never happened in advance of a recession.
Carl: the BNP Paribas quote your reference is itself misleading. It is not necessarily the case that banks create money when purchasing bonds from a non-monetary entity. A bank that receives an inflow of deposits necessarily must invest the money in something (e.g., by buying bonds), and that transaction does not create any new money.
Bernanke conducted the most contractionary monetary policy since the GD. Powell created the most expansive monetary policy ever. While inflation is subsiding, it is not going away. So, unless there's a lot of unsold inventory, I don't expect housing prices to revert to mean.
A 2% inflation target seems unachievable. It took years for Volcker's inflation to subside, and he had a lot of help from the DIDMCA of March 31st, 1980.
Link: Daniel L. Thornton, May 12, 2022:
“However, on March 26, 2020, the Board of Governors reduced the reserve requirement on checkable deposits to zero. This action ended the Fed’s ability to control M1."
TMS and Divisia Aggregates have turned negative. The rate-of-change in currency in circulation is back to 2010 levels. The 6-month roc in our means-of-payment money has turned negative. When the 10-month roc turns negative there will be a recession. But now the FED won’t know about it after a lag.
Unbeknownst to the FED's Ph.Ds., the distributed lag effect of money flows, the volume and velocity of money, are mathematical constants. There is no “Fool in the Shower”.
Never are the commercial banks intermediaries in the savings-investment process. From the standpoint of the entire payment’s system, commercial banks never loan out, and can’t loan out, existing funds in any deposit classification (saved or otherwise), or the owner’s equity, or any liability item.
Every time a DFI makes a loan to, or buys securities from, the non-bank public, it creates new money – demand deposits, somewhere in the system. I.e., all deposits are the result of lending and not the other way around.
Contrary to the smartest guys in the room, all monetary savings originate within the payment’s system. The source of interest-bearing deposits is non-interest-bearing deposits, directly or indirectly via the currency route (never more than a short-term seasonal situation), or through the bank’s undivided profits accounts. This is the cause of secular stagnation, the deceleration in velocity. I.e., all bank-held savings are lost to both consumption and investment, indeed to any type of payment or expenditure.
That's why Dr. Philip George's "The Riddle of Money Finally Solved" works. In Alfred Marshall’s “Cash Balances Approach” (the demand for money), K = “the length of the period over whose transactions purchasing power in the form of money is held”. K is related to Vt; it is the reciprocal.
Link https://www.federalreserve.gov/econres/notes/feds-notes/understanding-bank-deposit-growth-during-the-covid-19-pandemic-20220603.html
re: "A bank that receives an inflow of deposits necessarily must invest the money in something (e.g., by buying bonds), and that transaction does not create any new money."
That's wrong. The acquisition of earning assets by the banks, except where interbank transactions are involved, always brings about an expansion in the money supply, ceteris paribus.
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