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Central bankers meeting this week in Jackson Hole likely will be talking about everything BUT what matters the most: the balance between the supply and the demand for money. Incredibly, our central bankers have failed to notice the monetary elephant in their living room for the past 3+ years.
I've been writing extensively about money in the Covid era since October 2020. As I noted back then, strong growth in M2 in 2020 was driven by a huge increase in money demand. That's why rapid M2 growth wasn't inflationary in the beginning.
Inflation didn't start showing up until 2021, when Covid fears began to ease and the economy began to get back on its feet. Rising confidence meant that people no longer needed to hold tons of money in their bank accounts. Declining money demand at a time of abundant M2 unleashed a wave of inflation. It wasn't until a year later—March '22—that the Fed (very belatedly) took steps to bolster the demand for money by raising short-term interest rates. Sharply higher interest rates over the past 16 months have had their intended effect: the public has become much more willing to hold on to the huge excess of M2, even as excess M2 has been declining. Falling inflation is the result. Money supply and money demand have moved back into rough balance.
Contrary to all the hand-wringing in the press (e.g., will the Fed need to crush the economy in order to bring inflation down?), and as I've been arguing for months, inflation has all but disappeared, even as the economy has remained healthy throughout the tightening process.
Chart #4 compares the growth of M2 to the rate of inflation according to the CPI. Note that CPI has been shifted to the left ("lagged") by one year. Thus, changes in M2 growth are reflected in changes in inflation about one year later. Slowing growth in M2 is beating a path to lower inflation.
Contrary to all the hand-wringing in the press (e.g., will the Fed need to crush the economy in order to bring inflation down?), and as I've been arguing for months, inflation has all but disappeared, even as the economy has remained healthy throughout the tightening process.
There is still plenty of money in the economy. This tightening cycle has been very different from past episodes, because this time the Fed has not had to shrink the supply of bank reserves. As a result, there is still plenty of liquidity in the market. Swap and credit spreads are correspondingly low, and that implies little or no risk of a recession for the foreseeable future.
Markets are on edge, worrying that the Fed will need to keep rates very high for a long time to come. Those fears are misplaced. It won't be long until both the market and the Fed realize that lower interest rates have become the big story.
Some updated charts that incorporate yesterday's M2 release for July:
Chart #1
As Chart #1 shows, the M2 money supply continues to follow a path back to its long-term trend (6% per year since 1995). The "gap" between M2 today and where it would have been in a more normal world has fallen by half since its peak in late 2021. Excess M2 supply is declining at the same time as M2 demand has increased thanks to aggressive Fed rate hikes. This implies reduced inflation pressures—which is exactly what we have been seeing.
Chart #2
Chart #2 shows the amount of US currency in circulation (this includes all the $100 dollar bills circulating in Argentina as well as in other countries with unstable currencies). Currency in circulation is an excellent measure of money demand, since unwanted currency is easily converted into interest-bearing deposits at any bank. People hold currency only if they want to hold it. Slow growth in currency is telling us that the demand for money is easing—but not collapsing. According to this chart, currency in circulation is only about $70 billion higher than it might have been had the Covid shutdowns and massive government spending not occurred (the 6% trend line has been in place since 1995).
Chart #3
Chart #3 compares the growth rate of M2 to the level of the federal budget deficit. It's quite clear from this chart that $6 trillion of government "stimulus" spending was monetized. It's also clear that even as the deficit has again been rising, M2 continues to shrink. Rising deficits do not pose a risk of rising inflation this time around—at least so far. Rising deficits are being caused almost exclusively by excessive government spending, and that is the problem going forward. Government spending squanders the economy's scarce resources and saps the economy of energy by weakening productivity growth.
Chart #4
34 comments:
S&P’s recent downgrading of US banks tells us that the next Fed move should be easing to foster a yield curve that strengthens bank balance sheets and credit standing.
Thank you, Scott.
There's a current buzz that the Fed might accept a higher inflation target, perhaps 2.5 or 3. As you point out, the rationale would be erroneous, but the outcome could be positive?
re: "Excess M2 supply is declining at the same as M2 demand has increased thanks to aggressive Fed rate hikes"
Rare insight. The proportion of gated deposits to transaction deposits balanced in April.
Velocity is still increasing:
https://fred.stlouisfed.org/series/WRMFNS
sADr. Philip George says: “The velocity of money is a function of interest rates” and
“Changes in velocity have nothing to do with the speed at which money moves from hand to hand but are entirely the result of movements between demand deposits and other kinds of deposits.”
Fed’s 2% stated goal is kinda silly. Inflation has averaged nearly 4% annually over the past 50 years.
Scott, May I use charts 3 and 4 in an article I am writing? I will give you credit for the charts in the article.
Scott, thank you for so many great insights and articles on inflation. Can you shed any light on why the 10-year US Treasury bond has risen by over 50 bps in the last two months? What is the bond market signaling?
The FED can lower its administered rates, but it must hold the money stock constant for another 8 months.
Junkyard: you are welcome to use the charts.
Duane: the 10-yr Treasury yield has jumped up because the market is worried that recent signs of strength in the economy will spook the Fed and they in turn will either raise rates more or keep rates higher for longer than the market had been expecting.
Vandy, re long term inflation average. Your choice of 50 years happens to include the very inflationary 1970s. Prior to Covid, the CPI averaged 2.4% for the previous 40 years, 2.18% for the previous 20 years and 1.76% for the previous 10 years. Including the Covid years, CPI has averaged 2.56% for the previous 20 years.
I would argue that the Fed should adopt a 0% target. Why guarantee that the dollar will lose value in the future? That only benefits debtors, and the US govt is the biggest of them all. It hurts the little guy the most, since he/she doesn't have easy access to inflation hedges.
Scott, the 100 year average is 3%.
I respectfully disagree. Some inflation is not a bad thing.
Contrary to the conventional wisdom, money is not neutral. During the U.S. Golden Age in Capitalism, if you exclude the Korean War, 1955-1964, the rate of inflation, based on the Consumer Price Index, increased at an annual rate of 1.4 percent.
R-gDp, not optimized, averaged 5.9% during 1950-1966 (in spite of the 3 recessions).
According to Corwin D. Edwards, professor of economics, Ph.D. Cornell University, the U.S. Golden Age in Capitalism was driven by “increased money velocity which financed about two-thirds of a growing GNP, while the increase in the actual quantity of money has finance only one-third.”
I.e., the nonbanks grew faster than the banks, making the bankers jealous.
The economic solution is to drive the banks out of the savings business.
"As money market mutual funds buy US Treasury bills that are now yielding more than the ON RRP offer rate, non-banks' funds are migrating from the facility to Treasuries"
https://research.stlouisfed.org/publications/economic-synopses/2023/08/23/the-mechanics-of-fed-balance-sheet-normalization
There's a difference between liquid assets and means-of-payment money. QT needs to continue. Interest rates, the administered rates, need lowered.
Bernanke held the money stock constant for 4 years. Powell needs to hold DDs constant for 2 years.
Vandy: The optimum rate of inflation is something about which reasonable people can disagree.
Re Powell's speech at Jackson Hole today: He said nothing new. He continues to adopt a hawkish attitude because he is still struggling to recover from his mistake a few years ago when it took him way too long to realize that inflation was more than just a "transitory" phenomenon. Unfortunately he is going to repeat his mistake again: always being slow to see what is happening on the margin.
I don't see another hike at this point. The only issue now is when the cuts will begin. The market is thinking we won't see a cut until maybe mid-year 2024. I continue to believe it will happen well before that, and quite possibly before the end of this year.
So JH has now become a non-event. They didn't discuss the money supply and they are trying very hard to convince the world that they are not going to let inflation get away from them again. That's been the story for awhile now. Sigh
Thanks Scott. I’ve positioned some of my portfolio anticipating treasury yields having peaked. Unfortunately this 50bp technical bump is no fun from a MTM perspective.
But you mention Argentina. I’m not holding my breath on Milei winning. And even if he does, passing many of his proposals would be nearly impossible. Plus I hear he’s quite eccentric. But watching him on youtube interviews, boy would it be a dream to test-drive his austrian economics.
As a bond trader I'm starting to think that the recent jump in long yields has less to do with perceived inflation and what the fed may do and more to do with the runaway debt that the US is accumulating and that the fed is a net seller of bonds and not a buyer and longer. If I'm right, long rates could be with us much longer than we once thought.
Thank you Scott for your excellence and for all the contributors on this page. Perhaps someone can help me: It seems that long term bonds (and even the 10 year) should go down as short term rates go up. Wouldn't the assumption be that if the Fed stays high, that inflation will be beat and before too long the rates will come down? As opposed to a premature pivot by the Fed that would, hypothetically, result in future inflation. If you're buying a 10 year bond I would think you would be more concerned about years 3-10 than 1&2.
First, Salmo deserves credit for calling a top in the market a few weeks ago.
Second, however, after years of hearing this from Salmo: “bank savings are frozen to the economy”, “banks don’t lend deposits” and “get banks out of the savings business” (paraphrasing more or less), I have never really understood what he is saying.
If banks create money by making loans, and thus deposits, how could you possibly get them out of the savings business since those deposits have to balance those loans? (and I am looking at the macro scale, not just the individual bank). And how could those deposits/savings not be productive since they will gradually become part of the payment system as investments are made?
Savers never transfer their funds outside the payment's system unless they hoard currency or convert to other National currencies. The NBFIs are the DFI's customers.
It’s stock vs. flow. Savings aren’t synonymous with the money supply. From the standpoint of the commercial banks the savings practices of the public are reflected in the velocity of their deposits, and not in their volume.
Whether the public savers, dissaves, chooses to hold their savings in the commercial banks or transfer them through intermediary institutions will not, per se, alter the total assets or liabilities of the commercial banks nor alter the forms of these assets and liabilities.
Contrary to Dr. George Selgin, all monetary savings originate within the payment’s system. There is just a shift between transaction’s deposits and gated deposits.
There is a one-for-one correspondence between demand and time deposits (as loans = deposits). As time deposits are grow, transaction’s deposits are depleted (currency notwithstanding).
The 39-year-old bull market in bonds occurred because the composition of the money stock changed. Velocity fell. Since C-19, it has partially reversed. Velocity has risen.
Economists simply haven't been able to fashion the banks in a system's context. Bankers pay for the deposits that the system already owns, the deposits that the FED decides they should have. The lending capacity of the banking system is not dependent upon the savings practices of the nonbank public, it is dependent upon monetary policy. The banks could expand credit even if savers ceased to save altogether.
So, the demand for money, as Dr. Philip George says, is the Riddle of Money Finally Solved.
The really interesting upcoming thing is the big drop in inflation in 2024. The distributed lag effect of money flows tends to have a wave effect. It acts like the "base effect". The expansion of the wave in 2022 will be dampened / exhausted in 2024. It echos, like in 1982.
Salmo - more tid bits to pique one's thought - can you flush that out a bit more - how did the money stock composition change - in the early 1980's? and how did this play out in bond prices?
Scott, I find it a slightly disturbing analogy that you give about money supply and demand. If I am reading you correctly you are saying that the Fed should supply money (deposits) when the public wants it, but that it must take it away when the public no longer does. That sounds like an easy task, but it is not, i.e. it is not easy to take it away - exactly what happened after 2008 - there never was the reigning in of the trillions of Reserves created.
The problem is, is that it is never clear when a crisis is over and tightening can resume - for fear of causing another crisis. And, anyway, everyone knows once you give, it is much harder to take back. And, then, there is the next crisis around the corner …
The answer is to not keep supplying the public (the financial world) with easy money everytime there is a crisis.
Richard: when the public no longer wants to hold all the money the Fed has supplied, the Fed needs to either 1) withdraw the money or 2) increase the public's willingness to hold the extra money by raising short-term interest rates. The latter is what they have been doing since early last year, and it's working.
@Richard
Contrary to popular belief, from the standpoint of the system, banks are credit creators, not credit transmitters. It is stock vs. flow. Banks don't lend deposits. All bank-held savings are lost to both consumption and investment, indeed to any type of payment or expenditure.
The DIDMCA of March 31st, 1980, turned the thrifts into banks. And it deregulated interest rates. It led to an increasing proportion and increasing volume of savings being impounded in the payment's system. This destroyed the velocity of circulation, and lowered AD.
The ratio of TDs to DDs grew at increasing rates of change. Then Bernanke remunerated IBDDs further reducing the velocity of money. This caused secular stagnation. The 39-year bull market in bonds was the result.
Japan's "lost decade" is a good example. The BOJ has unlimited transaction deposit insurance, the Japanese save more, and keep more of their savings impounded in their banks.
“Japanese households have 52% of their money in currency & deposits, vs 35% for people in the Eurozone and 14% for the US.”
Any institution whose liabilities can be transferred on demand, without notice, & without income penalty, via negotiable credit instruments (or data pathways), & whose deposits are regarded by the public as money (e.g. E-$ market), can create new money, provided that the institution is not encountering a negative cash flow.
From a system’s perspective, commercial banks (DFIs), as contrasted to financial intermediaries (non-banks, NBFIs): never loan out, & can’t loan out, existing deposits (saved or otherwise) including existing transaction deposits, or time “savings” deposits, or the owner’s equity, or any liability item.
When DFIs grant loans to, or purchase securities from, the non-bank public, they acquire title to earning assets by initially, the simultaneous creation of an equal volume of new money (demand deposits) - somewhere in the payment’s system. I.e., commercial bank deposits are the result of lending, not the other way around.
The non-bank public includes every institution (including shadow-banks), the U.S. Treasury, the U.S. Government, State, & other Governmental Jurisdictions, & every person, etc., except the commercial & the Reserve banks.
That explains why Scott Grannis maintains that the supply of and demand for money is the "most important variable" that's ignored. That's the basis for Dr. Philip George's "The Riddle of Money Finally Solved".
Thanks Scott for your response. Yes, but “increase the public's willingness to hold the extra money by raising short-term interest rates” is not the same as “withdraw the money”. The former slows down money creation (until the next crisis caused by this raising of interest rates), but it does not reduce it (unless the Fed is willing to cause a depression. I don't think so).
We want to stop these cycles of boom bust by not allowing the Fed to keep priming the pump everytime the public, during some crisis, has "demand" for money.
Salmo, everything you say seems to make sense, but I still do not understand how you get from these things to "bank savings deposits are lost to the economy" i.e not productive you have said more or less.
Please correct me but this is how I see it (in a hypothetical world with all banks making good loan decisions, credit, duration, etc.):
1. The non-bank public wants loans for investment or consumption.
2. Banks make these loans, and, in so doing, create deposits.
3. In order for banks to hold on to their loans and/or other assets, banks must pay interest to keep these deposits.
4. The banks make money on the interest differential.
5. The deposits are eventually used for investment or consumption (at a rate of withdrawal that a bank can adjust for).
6. Conclusion: the deposits at banks are used for productive purposes.
Bank lending is a function of the velocity of deposits, not their volume. It is a system's process, not an individual bank's process. Obviously, the individual banker can't operate with a negative cash flow, it must maintain a positive balance of payments.
The individual banker’s operative delusion stems from their everyday experience, that a bank’s lending capacity is increased when funds flow into the bank, which build up his bank’s clearing and correspondent balances (its legal lending capacity), and insofar as the funds are not required by law as a reserve against the incremental deposits inflow, can be used to buy securities or make loans. I.e., the lending equation, L = S(1-s), for a single commercial bank is comparable to a non-bank conduit.
Why are the time deposits not invested? Simply because the DFIs are carrying on their balance sheet a liability that is owned by the non-bank public. That cannot be used unless the nonbank public decides to use it, and by definition it is not being used.
Debits aren’t to the depositors’ accounts. Credits, ex nihilo, are to the borrowers’ account. The whole is not equal to the sum of its parts in the credit creation process.
“The growth of time deposits (the shift from demand to time deposits), shrinks aggregate demand and therefore produces adverse effects on gDp"
"The only relevant test of the validity of a hypothesis is comparison of prediction with experience." – Nobel Laureate Dr. Milton Friedman
Looks like bonds are "calling the tune".
The Fed does not print money. Regulated banks do, when they extend loans. (There is a side argument about QE, but let that go for now).
https://fred.stlouisfed.org/series/BUSLOANS
This chart shows loan volume peaked back in January, and has been declining since.
I think the Fed has overdone it. No one likes inflation, but a few years above the 2% target is not the end of the world.
Workers looking for work and getting hired is not a bad outcome.
Salmo, I get what you're saying: banks can't loan their liabilities. Nor do the depositors use (invest, spend) the money if it's in time deposit accounts. Right. So, what this comes down to is:
1. Public takes loans (the creation of deposits) at some interest rate from banks,
2. If the public takes these deposits and puts them into time deposits (at some lower interest rate), there is no economic activity (except the money differential in interest rates that the banks make).
Obviously, this makes no sense for the public over the long run. But is this really what happens? No, I don’t think so.
In fact, the non-bank public takes these loans for some consumption/investment purpose. In the meantime, yes, they may put some of these loans in time deposits, but eventually they will be spent/invested. This is productive.
If banks didn’t pay interest on their time deposits in the meantime, the public would be less likely to get loans to begin with, which would mean lower consumption/investment.
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