M2 still points to lower inflation

The Fed recently released the March money supply numbers, and the story hasn't changed. M2 surged from early 2020 through early 2022, thanks to $6 trillion of deficit spending that was effectively monetized. Since its peak in April '22, M2 has declined by almost $1 trillion. This all adds up to the biggest seesaw in U.S. monetary history. As the dust continues to settle we see that a lot of the excess growth in M2 has been absorbed by a bigger economy and suppressed by higher interest rates, which have boosted the public's willingness to hold onto the extra money. The question now is not whether inflation will rise, but rather how much further it will decline. 

Chart #1

Chart #1 shows the history of M2 growth (plotted on a logarithmic y-axis so as to show constant rates of growth as straight lines). The huge bulge in M2 which began in Q2/20 was fueled by about $6 trillion in Covid "stimulus" checks which were effectively monetized (not borrowed, but printed) and largely sat in people's checking accounts for almost two years. (Prior to this, deficit spending by Treasury was routinely financed by selling bonds, which created no new money as a result.) The "bulge" in M2 rose to a high of $4.7 trillion in Dec. '21, and has now fallen by almost two thirds. This was the result of negative growth in M2 and ongoing growth in the economy. 

Chart #2

Chart #2 shows the growth of currency in circulation. This is a fairly good measure of money demand, since no one holds onto currency without a reason to do so. Excess, or unwanted currency is easily returned to the banking system in exchange for interest-bearing deposits. This chart demonstrates the significant increase in money demand from 2020 through late 2021, a time when uncertainties were running rampant and it was difficult to spend money. Since early 2022 money demand by this measure has returned to "normal." Rising money demand kept the bulge in M2 from being inflationary, while declining money demand coincided with an increase in inflation. In short, for the past two years the increase in inflation that has proved so distressing was simply the result of unwanted money being spent: too much money chasing too few goods. Money demand has apparently returned to more normal levels now, so, with a lag, inflation is likely going to continue to decline.

Chart #3

Chart #3 is my definition of money demand: M2 divided by nominal GDP. This is best thought of as the percentage of total income (GDP) that the public chooses to hold in the form of readily spendable cash (M2). Here we see that money demand—after surging in the wake of the Covid panic—is rapidly returning to what might be termed normal. 

Chart #4

Chart #4 compares the year over year growth of M2 with the year over year change in the CPI, which has been shifted to the left by one year to suggest that there is a one-year lag between changes in M2 and changes in inflation. The red asterisk at the Mar. '24 mark is the rate of CPI inflation ex-shelter (see this post for a more detailed explanation). It would appear that the lag has lengthened a bit to perhaps a year and a half. That further suggests that given the decline in M2 we are likely to see further declines in inflation over the balance of this year. 

GDP update: moderate growth and disinflation continue

Markets have over-reacted to today's first quarter GDP stats. Quarterly numbers are by nature volatile; it's more important to look at them in a broader context, which the following charts provide.

Chart #1

The first estimate of Q1/24 GDP growth came in weaker than expected (1.6% vs 2.5%). But as I see it, that merely corrected for some stronger-than expected numbers in Q3 and Q4. On balance, and as Chart #1 shows, real GDP is growing at about a 2.2% annual pace. It's actually a bit below the 2.2% trend growth pace which began in mid-2009. It's unremarkable, as I've been saying for a long time. What's really remarkable is that the economy today is about 20% smaller than it could have been had it continued the 3.1% growth trend that prevailed from 1966 through 2007. A lot of money has been left on the growth table! That should be the big story. 

Chart #2

Chart #2 shows the year over year change in the GDP deflator, the broadest measure of inflation that exists. On a quarterly basis, the deflator grew at a 3.7% annualized rate, which was a bit higher than the market's 3.4% expectation. Does this qualify as "hot"? Hardly. On a year over year basis the deflator rose only 2.4% and there is every reason to think that it will continue to moderate over the course of this year, for the same reasons I have argued that CPI inflation will moderate.

On balance, I see no reason to worry about a near-term recession, nor to worry that the Fed has not done enough to tame inflation. Swap and credit spreads remain very low, the banking system is flush with liquidity, financial conditions are quite healthy, the stock market is healthy, the dollar is strong, unemployment claims are low, job gains continue at a reasonable pace, and there is little risk of an imminent increase in tax or regulatory burdens.

Belated March CPI analysis

I've only recently returned from several weeks in Argentina. I didn't have access to my charts, and besides, I was rather more interested in people, food, and wine than in blogging. Time now to catch up on the market's latest focus: Is inflation still stubbornly high? Does the Fed need to tighten more?

The March CPI release was, in retrospect, the one that apparently convinced the Fed and the market that "disinflation has stalled." More recently, the market, with encouragement from numerous Fed governors, has come around to thinking that instead of cutting rates five times by the end of this year, we might see, at best, one cut, because the Fed has more work to do. "Higher for longer" is now the interest rate mantra that is driving the market; it's made people nervous, so an equity market correction is underway.

You won't be surprised to learn that I disagree. I still think the great inflation bubble that started three years ago has long since popped. And the main reason inflation is still marginally higher than where the Fed would like to see it is the way shelter costs are calculated. I think the following charts make that clear.

Chart #1

Chart #1 compares overall inflation to inflation less its shelter component, which is about one-third of the total. Both are calculated on a 6-mo. annualized basis, which is the best way to see if recent developments mark a change in the broader trend. My first take when looking at this chart is that if there is an inflation problem in today's numbers, it pales in comparison to the numbers we saw in the 2005-2009 period. 

Looking closer, I note that the 6-mo. annualized rate of inflation less shelter has averaged 1.6% for the past 16 months, and it has been more than 2.0% in only four of those months. Moreover, there is no sign of any meaningful recent acceleration: it has averaged only 2.01% over the past 4 months and it was 2.06% in March '24. As for the overall CPI, it has averaged 3.3% over the past 16 months, and it was 3.3% in March '24. The difference between the two is due entirely to shelter costs, which, arguably, have been artificially inflated by the way BLS calculates them.

Chart #2

Chart #2 shows that the year over year increase in shelter costs as calculated by the BLS is driven almost entirely by the year over year change in nationwide housing prices 18 months prior. (The red line has been shifted to the left by 18 months, and the two lines match up almost exactly.) Even though housing price inflation has dropped significantly from its peak two years ago, and nationwide rents have been flat to down over the past year, the BLS calculates that shelter costs currently are rising at the rate of 5.9% per year. If the relationships in this chart hold, then the rise in shelter costs will reach a low point this coming October (which is the point where the blue line falls to zero). In other words, shelter costs will almost certainly continue to decline every month from now until October, and that will subtract significantly from the increase in the overall CPI.

Inflation is not a problem. The Fed once again is late to the party, as usual. If the Fed keeps short-term interest rates higher for longer it will only push inflation lower, and there's nothing necessarily bad about that. In any event, I'm willing to bet that interest rates don't remain at current levels for as long as the market is currently forecasting. At some point the Fed is going to figure out that it's done enough. 

MAGA down south

Before you read this post, please first read this post from 18 months ago. We are back in Argentina, and there have been some notable changes since our last visit.

By far the most significant change is Argentina's new President, Javier Milei. He's a libertarian and believes strongly in limited government and free markets. He is attempting a hard, far-right turn in Argentina's left-wing-damaged economy, which, if successful, could have ripple effects throughout the globe. He's only been in office since December, so the results are only visible if you know where to look, and I'll expand on that later. His objectives are straight out of the libertarian, free-market playbook: shrink Argentina's bloated government, kill inflation, gut regulations, eliminate subsidies, and root out corruption.

Since our last visit, the price level in Argentina has gone up over 4-fold; in percentage terms that's 4,430%. But the exchange rate has only increased almost 3-fold, or 260% (from 300 pesos per dollar then to about 1100 pesos per dollar now). As a result, Argentina is more expensive for a US tourist today than it was then. But it's still pretty cheap. The fish BBQ for four (actually four of us couldn't finish it) we had back then was $33, now it's $47. Excellent wine back then was $27, now it's $39 at our favorite Buenos Aires restaurant.

The most curious thing is that back then the largest denomination peso bill was 1000 pesos. A 2,000 peso note was subsequently released, but they are few and far between. In fact, I have only seen one after a week of looking—and I have yet to see any smaller bills. The 1000 peso bill today is worth about one US dollar, so let's call it Argentina's one dollar bill, and it's effectively the only bill you will see in circulation. Virtually all cash transactions are conducted with this bill, which means that everyone is walking around with a huge wad of $1000 peso notes in their pocket or purse. This also means that credit cards are essential for anyone expecting to make a payment of more than, say, $40-50 dollars.

Ubers are all over, and they are unbelievably cheap. My most expensive ride took us across town for about 20 minutes at 1:30 am. Uber charged me $5. I couldn't resist giving the driver the maximum tip Uber was willing to allow: $2.50. I would have loved to see his face when he saw that pop up on his screen! Most other rides of a couple of miles cost less than $2. Today's lunch at our small local hotel consisted of a glass of wine, a huge milanesa with an equally huge portion of real mashed potatoes, and an empanada. Total cost $12.

Any American who has heard of Milei will want to know the answer to this question: are the people willing to undergo a significant degree of hardship while he implements his draconian policies (e.g., slashing government spending, eliminating subsidies, firing tens of thousands of government workers, eliminating rent control)? Right now there is no question they will endure, because they know he is doing the right thing. Besides, they've suffered through so many hardships that one more is not going to be a deal-breaker.

I got together with a group of 8 local friends last night to talk about this and other things. The evening kicked off around 10 pm with some wine and hors d'oeuvres, followed by a delicious asado (bbq). Followed by more wine and some heated discussions. They were all quite positive about the future. I got back to the hotel at 3:20 am. I'm still recovering, but they all had to work today. These are the things I love about Argentina: great food, great wine, and great friends. Unfortunately the economy is anything but great.

Milei really should adopt Trump's MAGA slogan: "Make Argentina Great Again."

Moderate growth and disinflation still alive and well

A quick update to focus on some market-moving stats released today.

Chart #1

Chart #1 shows the results of the March survey of purchasing managers in the service sector (by far the largest part of the economy). It is consistent with the view I've maintained for well over a year, which is that the economy continues to grow at a non-spectacular pace.

Chart #2

Chart #2 shows that the number of firms that report paying higher prices continues to decline. This same statistic surprised to the upside in January, thus fueling speculation that maybe the Fed was right to move slowly on rate reductions. But as often happens, sudden jerks in monthly numbers are just flukes and subsequently reversed. Inflation pressures remain quite subdued; disinflation is still in place.

On balance, the picture is one of an economy that continues to grow while inflation continues to subside. The market, unfortunately, continues to harbor a long-ingrained reflex that says that in order for inflation to decline, the economy needs to weaken. Not so. Inflation is not growth-friendly. Low and declining inflation and moderate to strong growth can coexist indefinitely if the Fed is acting correctly.

Nothing in these recent stats argues for the Fed to refrain from lowering short-term interest rates. 

M2 update—still looking good

Today the Fed released the February money supply data, and there were no unwelcome surprises. M2 continues to shrink relative to the economy, and that's the reason inflation is likely to continue to fall.

Chart #1

Chart #1 shows the recent history of currency in circulation, which represents about 10% of M2. It rose at a fairly constant 6.6% annual rate from 2010 until early 2020, then surged (as did M2) from March 2020 through early 2021. I've assumed for years that this measure of the money supply is also a reliable measure of money demand, because people hold currency only if they want it. (Important note: there is no direct measure of money demand, and that's why it's hard for the Fed to keep the supply of and the demand for money in balance.) Any rational person with unwanted currency would simply return it to a bank in exchange for an interest-bearing deposit of one form or another. 

So the message of currency is that the demand for money exploded in the wake of the Covid crisis; everyone wanted more cash because there was so much uncertainty. And besides, it wasn't easy to spend money back then if you couldn't leave your home. But things started changing in early 2021 with the introduction of vaccines. Life slowly started getting back to normal. The demand for money began to subside. Today, currency in circulation has fully reversed its "bulge," and is back on its 6.6% annual growth track. 

Most important is the fact that if money supply and money demand are now roughly in balance, as seems to be the case, there is no reason to expect a meaningful change in inflation.

Chart #2

M2 grew at a 6% annual rate from 1995 through 2019. It then surged by some $6 trillion over the next two years, propelled by $6 trillion of government "stimulus" spending which was monetized. Deficit spending at all other times in recent history has been financed by selling Treasury debt. Not so this time, when the spending was effectively financed by newly-printed money. 

The initial surge in M2 was not inflationary because, as currency in circulation tells us, the demand for M2 was intense in the first year of soaring M2. But as the demand for money began to decline in 2021, excess money became inflationary as people began spending their surplus cash. This, coupled with supply bottlenecks, created a classic "demand-pull" inflation: too much money chasing too few goods.

M2 growth since early 2022 has been flat to negative, thanks in large part to the Fed's belated decision to jack up interest rates. Higher interest rates made M2 money more attractive, effectively neutralizing in large part the huge excess of M2 at the time. Although there is still some "excess" money according to this chart, it is not a source of inflation because interest rates remain high: extra money supply is countered by the extra demand for money that results from high interest rates.

Chart #3

Chart #3 illustrates how changes in M2 growth tend to precede changes in the CPI by about one year. That relationship appears to have broken down over the past 6-8 months, however. I think the reason for that is that the CPI is being overstated by the way the BLS calculates shelter costs. The red asterisk shows the year over year change in the CPI ex-shelter (1.8%) as of February '24; that's much more in line with the growth of M2. And it further suggests we have continued disinflation in the pipeline since shelter costs are almost surely going to decline over the next 6-8 months. 

Chart #4

Chart #4 shows another way of calculating the demand for money. It is simply the ratio of M2 to nominal GDP. You can think of it as a measure of how much of one's annual income one wants to hold in the form of money (cash, and cash equivalents). Here it is easy to see the sudden and tremendous surge in money demand in the early months of the Covid crisis. Then, starting about a year later, we see money demand plunging. At the current rate it should return to pre-Covid levels over the next year or so. We're almost out of the Covid woods, in other words.

Many will call this a "soft landing" or "no-landing" scenario. Because it will be the first time the Fed has wrestled inflation down from uncomfortably high levels without also triggering a recession. And the reason for that is the Fed's "abundant reserves" policy, which avoids creating a shortage of liquidity in the banking system. 

U.S. energy efficiency has soared

Since 1970, U.S. consumption of crude oil and petroleum products has increased by only 38%, yet the U.S. economy has expanded by a factor of 4.2. As a result, U.S. oil consumption per unit of output has fallen by two thirds. This is simply astounding. Do we really need to continue subsidizing "green" energy?  Do we really need to regulate internal combustion engines out of existence?

Chart #1

Chart #2

Financial Conditions look excellent

Here’s a very short post to highlight the excellent shape of today’s financial conditions. At the very least this adds up to one important conclusion: there is NO shortage of liquidity, and financial markets are thus free to do what they do best: namely, to redistribute risk away from those that don’t want it to those who value risk. This is a very important function of free markets, since it reduces the market’s overall level of anxiety, thus minimizing the risk of disrupting influences and panic.

Chart #1

Chart #1 shows Bloomberg’s index of financial conditions. The components of this index are at the bottom in fine print, and they represent a comprehensive array of risk indicators. By this measure, today’s markets have almost never been so healthy.

Chart #2

Chart #2 shows corporate credit spreads, the difference between the yield on corporate bonds of different quality and Treasury yields of comparable maturity. Spreads have rarely been tighter than they are today, which adds up to a strong vote of confidence on the part of the market regarding the future health of corporate profits, and by extensions, the prospective health of the economy. 

I would only add that the Vix Index (aka the Fear Index) is about as low as it gets. We are living in “untroubled” times by these measures. 

COVID lessons learned

Our COVID national nightmare began just four years ago, so now is a fitting moment to step back and review what happened and what we have learned as a result. The Committee to Unleash Prosperity, headed up by my good friend Steve Moore, recently published a study which compiles all that we have learned about COVID and the egregious attempts of many to deal with it. This needs to be widely distributed. I've summarized the 10 major lessons learned here:

• Leaders Should Calm Public Fears, Not Stoke Them
• Lockdowns Do Not Work to Substantially Reduce Deaths or Stop Viral Circulation
• Lockdowns and Social Isolation Had Negative Consequences that Far Outweighed Benefits
• Government Should Not Pay People More Not to Work
• Shutting Down Schools Was a Major Policy Mistake With Tragic Effects on Children, Especially the Poor
• Masks Were of Little or No Value and Possibly Harmful
• Government Should Not Suppress Dissent or Police the Boundaries of Science
• The Real Hospital Story Was Underutilization
• Protect the Most Vulnerable
• Warp Speed: Deregulate But Don’t Mandate

The 48-page study, authored by Scott Atlas, Steve Hanke, Phil Kerpen and Casey Mulligan, is chock-full of charts and footnotes. We cannot allow government to repeat these grievous errors ever again. Print this out and give it to your children.

If you haven't already, do subscribe to Steve's excellent newsletter Hotline (it's free). It comes out every weekday and is always full of interesting information that you might not see elsewhere.

Inflation is NOT running hot

Don't jump to conclusions based on one month's number.

The Final Demand version of the Producer Price Index rose 0.6% in February, and that was twice the amount the market expected to see. A Bloomberg headline this morning said "Bond Yields Jump as Hot Inflation Curbs Fed Wagers." Worse still, the full version of the PPI rose 1.4% in February. OMG! 

Well, the reality is VERY different, as these two charts show.

Chart #1

Chart #1 shows the level of the Producer Price Index. As the line in the upper right-hand corner suggests, prices have been unchanged since June '22. Monthly datapoints jump up and down quite a bit, but on balance, prices are going nowhere. In fact, the PPI is down 0.2% since June '22. Want more? Prices for unprocessed goods for intermediate demand (another subset of the PPI) have plunged by 31% since June '22. 

Chart #2

Chart #2 shows the 6-mo. annualized and year over year change in the Final Demand version of the PPI—the one that has given the market the willies this morning. What do we see? The year over year change in this measure of inflation today is 1.55%, and it has been less than 2% since April '23. 

Inflation at the producer level has not been a concern for many months. It's effectively dead.

If the Fed gurus have any sense at all, they will realize that there was nothing in today's news that would argue against a cut in short-term rates. 

Ex-shelter inflation has been less than 2% for 8 months

"Hot CPI" read the headlines today, referring to the 0.4% rise in the February CPI and the 3.2% year over year change in the CPI. My take: inflation is running hot only if you think it makes sense to look at the year over year rise in nationwide housing prices 18 months ago. If you omit that one item (which comprises about one-third of the CPI), then you find that the year over year change in the CPI has been less than 2% for the past 8 months.

Chart #1

Chart #1 illustrates how the BLS calculates the shelter component of the CPI. It's almost entirely driven by the year over year change in the Case Shiller National Home Price Index 18 months ago. To explain: the blue line is the year over year change in home prices. The red line is the year over year change in Owner's Equivalent Rent, which dominates the shelter component of the CPI, shifted 18 months to the left. That the red and blue lines track almost perfectly for the past several years is virtual proof that the BLS is using 18-month-old housing price changes to calculate one-third of the value of today's Consumer Price Index. It's crazy, and it's a well-known flaw in the calculation of the CPI.

Chart #2

Chart #2 compares the year over year change in the CPI and the CPI less shelter. There is a huge gap between the two which has persisted for over 8 months. That gap will almost certainly disappear over the next 6-7 months, since that will mark the zero % change in the blue line in Chart #1. 

Given that the stock market today shrugged off the disappointing CPI news, we can reasonably conclude that the world is aware of this problem. The world knows that inflation is under control and that sooner or later the Fed will begin reducing short-term interest rates.

Will someone please mention this to the members of the MSM?

A quick recap of the February jobs report

The February jobs report was impressive on the surface (+275K), but nothing to get excited about. Most of the recent strength in jobs comes from government hiring, which is the least likely to boost the economy's growth potential. Private sector jobs growth—the main source of the economy's vitality—has decelerated significantly over the past two years, and is now growing at a modest 1.6% per year. At best, this suggests the economy remains on a 2+% growth path. 

Chart #1

Chart #1 compares the growth of private and public sector jobs. Public sector jobs have grown by a robust 2.8% over the past year, while private sector jobs are up only 1.6% in the past year. The best that can be said of public sector jobs growth is that it has been very modest on balance since 2008. 

Chart #2

Chart #2 shows the year over year growth of private sector jobs. They were going gangbusters two years ago (up almost 6%), but for the past few months have eked out only 1.6% growth, which works out to monthly gains of about 180K per month. Very ho-hum.

Chart #3

As for the unemployment rate, it's quite low, and that's good. But it's no longer falling and could be on the verge of rising. This bears watching, since rising unemployment from very low levels is a classic sign of impending recession. 

Big Picture: private sector financial health excellent

Today the Fed published its estimates of the private sector's balance sheet and net worth, and it's nice to see that the numbers reflect very healthy conditions. (This is not a pitch that you will find in tonight's State of the Union address, but if Biden were smart he would reference these charts.)

Chart #1

As of year end 2023, the net worth (total assets minus total liabilities) of the US private sector was $156 trillion. As Chart #1 shows, most of the gains in net worth resulted from increased holdings of financial assets, which in turn represents savings and investments. Since 2007 (just before the onset of the Great Recession) financial assets have increased by 120%, while real estate assets increased 90% and debt increased by only 41%. 

Chart #2

But we can't ignore inflation, especially since we are only just now coming out of the highest inflation episode this country has experienced since WWII. Chart #2 adjusts the net worth numbers for inflation, and here we see that the inflation-adjusted peak in net worth was $164 trillion in late 2021. But as the chart also shows, the upward trend of real net worth remains unbroken.

Chart #3

We can't ignore inflation and we can't ignore the fact that the US population continues to grow; with more people working, it's natural to expect improvement in nearly all measures of net worth. So Chart #3 adjusts the net worth data in Chart #1 for both inflation and population growth. Here we see that per capita real net worth today is about 10-15% above its long-term trend. 

This chart is saying that the net worth of the average resident in the US is about $460K. While of course there are many billionaires and many with little or no net worth, the value of the homes, buildings, factories, roads, infrastructure, etc. in this great country add up to about a half million dollars per person. Everyone is able to enjoy the benefits of these assets, and our economy is able to employ just about all who are looking for a job. (The BLS recently reported that there are currently almost 9 million job openings and a little over 6 million who are actively looking for work. An individual's skills don't always match what employers are looking for, and salaries are not always as much as an individual might like, but there is no shortage of jobs in this country right now.)

Chart #4

Total federal debt owed to the public has reached almost 96% of GDP, and that is up by a staggering amount since 2007 when it was only 35% of GDP. But it is still only a fraction of the private sector's net worth, as Chart #4 shows. To simplify, households are asset-rich at a time when the public sector is heavily indebted. A large part of the government's debt, of course, is owned by US residents. 

Chart #5

Since the Great Recession, the private sector has reduced significantly its financial leverage. The Great Recession was caused in large part by a borrowing binge on the part of the public which imploded when real estate prices collapsed. We do not face that same problem today, that's for sure. Households' finances haven't been this solid since the late 1970s. 

Chart #6

Chart #6 shows the financial burdens of the household sector, defined as payments for mortgage & consumer debt, auto loans, rents, homeowner's insurance, and property tax as a percentage of disposable income. Looked at from an historical perspective, things have never been so good, except for the Covid era, when government stimulus payments temporarily showered the private sector with liquidity.

All of this is not to say the state of the union is wonderful. There is a litany of social and political problems that need addressing, and many people today are facing hard times if only because of the fallout of our recent inflation binge. I think the message here is that things aren't as bad as people seem to think they are. And of course, it's also true that things could be a whole lot worse than they actually are. 

I think the stock market is in substantial agreement with me on this.

M2, inflation & economy update

This post includes important updates on the M2 money supply, inflation, and key economic indicators.

The all-important M2 money supply continues to come back into line with long-term trends, key inflation measures are very close to the Fed's target, and money demand is returning to pre-Covid levels. The service sector (dominated by housing-related costs) is the only area of the economy suffering from above-average inflation at this time, but this should gradually subside over the next 6-9 months. Memo to Fed: you can start reducing short-term interest rates anytime, and the sooner the better.

Surveys of purchasing managers and capital goods orders suggest the economy is on an unremarkable (~2%) growth path. 

Fiscal policy is dominated by an excess of spending and a sharply worsening debt financing problem. While deficit-financed spending may have helped the economy in recent quarters, too much spending can only act as a productivity-sapping headwind to growth in coming years.

Chart #1

Chart #1 compares the level of the M2 money supply to its post-1995 trend line. $6 trillion of deficit spending was monetized in 2020-21, pushing M2 sharply higher and eventually causing a sizable surplus of money. Too much money then drove inflation higher. This has largely reversed over the past two years, thanks to the restrictive Fed policy which has kept short-term interest rates high. 

Chart #2

Chart #2 compares the level of currency in circulation to its post-1995 trend line. Currency is a key measure of the money supply because it is the only direct measure of money demand; people hold currency only if they want to. Unwanted currency can be returned to banks in exchange for deposits and ultimately be absorbed by the Fed. The 2020-21 pickup in currency growth confirms my view that rising money demand initially neutralized the monetization of $6 trillion of Covid stimulus spending, but that was followed by declining money demand which fueled rising inflation as people sought to reduce their money balances.

Chart #3

For many years I have called Chart #3 the most important chart of monetary conditions that hardly anyone looks at. It measures what I call "money demand." It is calculated by dividing the M2 money supply by the level of nominal GDP. Conceptually, this is similar to calculating how much of one's annual income is held in cash and cash equivalents. For many years (1959-1987) this ratio was remarkably stable, but since then it has become quite volatile. It is now closing in on pre-Covid levels, which likely presages a return to stable money demand—and by extension, in the context of very slow M2 growth—low and stable inflation.

Chart #4

Chart #4 shows the year over year change in the Core and Total version of the PCE deflators. By these measures, inflation is within inches of returning to the Fed's target level.

Chart #5

Chart #5 shows the three major categories of PCE prices: services, durable goods, and non-durable goods. Note that the latter two have exhibited essentially NO increase for the past two years! The inflation that shows up in the PCE deflator (Chart #4) comes exclusively from the service sector, and that sector in turn is dominated by calculations of the cost of "shelter." As I and others have been pointing out for the past year or so, these calculations are highly correlated to housing prices 18 months in the past. If they instead were correlated to changes in housing prices over the past 6-9 months, service sector inflation today would be approaching zero.

Chart #6

Chart #7

Charts #6 and #7 show survey results from purchasing managers in the US and Eurozone. Based on these surveys, it is clear that the manufacturing sector is suffering from very weak growth conditions. The much larger service sector, on the other hand, appears to be experiencing average growth conditions, at best. 

Chart #8

Chart #8 shows the nominal and real (inflation-adjusted) level of capital goods orders. Capex spending is a good proxy for business investment in new plant and equipment, which in turn provides the seed corn for future productivity gains. Stagnant capex spending in recent years suggests meager productivity growth in coming years, and only modest overall economic growth.

Chart #9

Chart #9 shows the level of federal government spending and revenues (calculated using a 12-month rolling total of each). Note the y-axis is logarithmic, which means that straight lines reflect constant rates of growth. How many are aware that federal spending has grown almost six-fold since 1990?

Chart #10

Chart #10 puts federal spending and revenues into an appropriate context, by comparing them to nominal GDP. Here we see that the growth of spending and revenues has largely tracked the growth of nominal GDP. Spending today is significantly higher than its post-war average, while revenues are only marginally lower. Spending is what's driving deficits, not a lack of revenues.

Chart #11

Federal debt owed to the public has now reached $27.4 trillion, or about 95% of nominal GDP. That's very high from an historical perspective, but the true burden of the debt is how much it costs to finance, which is shown in Chart #11. It won't be long until interest costs swell to a record level relative to GDP, even if the Fed starts to lower short-term interest rates as the market expects.

Important point that most people are unaware of:

Our mountain of federal debt is the source of much gnashing of teeth and cries of impending doom. What's missing from all the shouting is this: making payments on a gargantuan amount of debt does not equate to flushing money down the toilet. Interest paid on federal debt is a burden to taxpayers, to be sure, but it is a source of income to those holding the debt. It's a zero-sum game: no money is destroyed in the process, it simply changes hands. 

What is important, however, is this: when the debt is the result of excessive government spending, this means that the economy is squandering its resources. Why? Because government spending is almost always less efficient and less productive than if the private sector were spending the same amount of money. Just think of all the hundreds of billions of fraud that accompany every big government spending program. 

To paraphrase Milton Friedman: debt is not the problem; spending is the problem. 

UPDATE (3/6/24): Chart 12 below illustrates the economy's growth path in recent years, which has been slightly more than 2.2% per year. The 3.1% trend line comes from the economy's growth path from 1965 through 2007; the economy is currently about 19% smaller than it would have been had we continued on a 3.1% annual growth path. Whichever policies caused the economy's growth path to downshift from 2008 on have proved terribly expensive. My working hypothesis is that the culprit is a big increase in transfer payments beginning in 2008 which in turn coincided with a significant drop in the labor force participation rate. 

Chart #12

The CPI overshoot is a statistical artifact

The January CPI overshot expectations by 0.1% and the stock market had convulsions. It's absurd. 

If it weren't for shelter costs, which now comprise 25% of the CPI, the year over year change in the CPI would have been 1.6%, well below the Fed's target and very good news for everyone. But the way the BLS calculates shelter costs has boosted the reported year over year change in the CPI to 3.1%. Over the next 9 months, it is highly likely that shelter costs will fall by more than half, thus subtracting significantly from reported CPI. Meanwhile, the ex-shelter version of the CPI has been very well-behaved. 

This is all a statistical tempest in a teapot. 

Chart #1

Chart #1 shows the reported change in the CPI (blue line, 3.1%) and what it would have been ex shelter costs (red line, 1.6%).

Chart #2

Chart #2 shows us that the Fed's method for calculating shelter costs today (the majority of which comes from Owner's Equivalent Rent) has a very high correlation with the change in housing prices 18 months ago. Absent any change in this methodology, we can predict that the change in OER will fall from the current 6.2% to 2.8% over the next 9 months. Thus, future declines in OER, which are virtually baked in the cake, will subtract over half of the difference between the headline CPI and the ex-shelter CPI between now and September '24. 

Chart #3

Chart #3 shows the level of the Consumer Price Index ex-shelter costs. Note the rapid growth from mid-2020 to mid-2022, when the index rose over 23% (which translates into an annualized rise in prices of over 11.9%). Now note how the growth of the CPI ex-shelter slowed dramatically beginning in mid-2022. Since June 2022, the Consumer Price Index has increased at a benign rate of 1.2% per annum, and as noted above, it has increased 1.6% in the past 12 months with no signs of any acceleration. Once again, it is safe to conclude that shelter costs and the way they are calculated have clearly overstated inflation. 

The Fed will figure this out sooner or later. Meanwhile, short-term interest rates will be higher than they need to be, but not forever. Monetary policy is "restrictive" only in the sense that borrowing is more expensive than it needs to be. But because bank reserves are super-abundant (see Chart #2 in my last post), liquidity is abundant and the economy can continue to grow as it has in the past year or so—despite higher-than-necessary interest rates. 

S&P 500 @ 5000

Today the S&P 500 index (considered by most professional investors to be the toughest index to beat) climbed past 5000, a milestone of sorts. To put this into perspective, here is a chart that shows the S&P 500 index from 1950 through today. As the green line indicates, the index (sans dividends) has risen at an annualized rate of about 8% per year. According to Bloomberg, and including reinvested dividends, the annualized total rate of return of an investment in the S&P 500 from Jan. 1950 through today works out to about 11.5%, for a total return of over 300,000%.

Over the same period, the CPI has increased 1,316%, or about 3.5% annualized per year. Roughly speaking, dividends over the past 74 years have offset inflation.

The power of compounding over long periods is truly remarkable.

Chart #1

It's a moderate-growth, disinflationary world

In my economic slowdown post a month ago I was generally upbeat, but I worried about the slowdown in job creation. Those worries faded with a strong January jobs number. The US economy is ok: credit spreads are still quite low, liquidity is still abundant, the dollar is still strong, inflation is still declining, and there are only a few indicators that suggest caution. Meanwhile, the Fed seems unduly concerned about the economy's strength (they now say they will have to wait at least several months before cutting rates), but that is nothing new. Keeping rates higher than necessary for a few months more than is necessary is not exactly a death knell for the economy. In the end, the Fed should know better: more people working means more demand for a money supply that is flat, and that is disinflationary.

Chart #1

Chart #1 shows that for decades the bond market has expected the Fed to deliver 2 - 2½ % inflation, and today is no exception. What stands out here is the dramatic rise in both real and nominal yields which began in early 2022 when the Fed belatedly realized that inflation was entrenched. As is usual, the Fed was late to the inflation party, but they reacted decisively by boosting real interest rates (the ones that really count) by over 400 bps in just one year. 

Chart #2

While the Fed's response was unprecedented in the magnitude and speed of rate hikes, it was also unprecedented given the utter lack of any restrictions on the supply of liquidity to the banking system. This shows up in the level of bank reserves (Chart #2), which has been in super-abundant territory ever since late 2008, when the Fed decided it would raise short-term interest rates directly and pay interest on bank reserves, which they then supplied generously. This had the effect of making bank reserves functionally equivalent to 3-mo. T-bills, while also boosting the quality of banks' balance sheets. Liquidity has been abundant ever since, in contrast to prior tightening episodes which invariably led to liquidity squeezes, bankruptcies, and financial panics. 

Chart #3

Chart #3 focuses on the all-important shape of the real yield curve (again: real (i.e., inflation-adjusted interest rates are the ones that really matter). As has been repeated ad nauseam by the financial press, inverted yield curves (when short rates are higher than long-term rates) typically precede recessions but that rule has long been broken, to the dismay of forecasters, most of whom neglected to focus on real interest rates. Chart #3 tells us that only now has the real yield curve inverted: the real Fed funds rate (which is an overnight rate) today is almost 3% (5.5% funds rate less 2.5% inflation), whereas the 5-yr real Treasury yield is almost 2%. As the chart shows, the blue line reliably has exceeded the red line prior to the last two significant recessions, as it has now. 

An inverted real yield curve is much more meaningful than an inverted nominal curve. Owning short-term risk-free assets today has become a very attractive proposition thanks to relatively high real rates. This is how monetary policy tightening works: it makes holding onto money (which includes short-term interest-bearing and highly liquid assets) more attractive than spending it. Better to have money than to hold commodities; better to have money than to borrow money. There's still loads of money out there, but high real rates are persuading people to hold on to that cash rather than spend it or borrow more. Just ask anyone with a floating interest rate loan these days and they will tell you that they can't believe how much their interest rate is re-setting this year. And the longer the Fed keeps the funds rate at 5.5%, the more floating rate loans are going to reset and the more painful all loans will become for borrowers.

So although no recession looms, neither does a boom. High real rates simply point to more disinflation.

Chart #4

Chart #4 shows the level of announced corporate layoffs according to the tally of Challenger, Gray & Christmas. It's a little on the high side today, but well short of being recessionary. The message here is that firms still have to fight to stay competitive, to cut costs, and to grow. That's healthy. 

Chart #5

Compare Chart #5 above to Chart #2 in my "Economic slowdown" post a month ago. Thanks to recent revisions to the jobs numbers, the recent pace of job growth has improved somewhat, but there is no denying that the pace of growth has been declining significantly for the past two years. While it's true that the pace of overall job growth looks better, that's because there has been a surge in the number of public sector jobs. My charts only refer to private sector jobs, which, like real interest rates, are the ones that really count. But they are only growing at a 1.8% annual pace, and that is a long way from fueling a boom.

Chart #6

I'll bet Biden and his handlers feel pretty good about Chart #6, because it shows a recent surge in consumer confidence. Confidence is still below average, but with a growing economy and plenty of money, it's not necessarily risky for Biden to ask for votes on the basis of how people feel about their current situation. Regardless, the one big problem that is unlikely to go away is the fact that, while inflation has returned to a semblance of normality, the big surge in prices of recent years has not reversed.  The sting of past inflation is still with us in the form of permanently higher prices for almost everything.

Chart #7

A quick check of credit spreads, such as those shown inn Chart #7, tells us that the outlook for corporate profits—and by extension the economy—is healthy. Spreads are quite low. This is very good.

Chart #8

Chart #4 in my last post told us that the inflation embers still burn, but mainly in the service sector, which in turn is dominated by wages. Chart #8 above reaffirms that message: the prices paid component of the ISM service sector survey shows a meaningful increase in the number of firms reporting paying higher prices.

Chart #9

Chart #9 shows that business activity in the service sector is healthy, but by no means robust. 

Chart #10

Chart #10 shows that the Eurozone service sector is obviously weak, while the US service sector is only marginally better.

Chart #11

Last month everyone worried about the huge decline in the ISM service sector employment index. Fortunately that was completely reversed in the February release. Last month was simply a fluke. These things happen, which is why you can't put a lot of trust in one month's numbers.

Chart #12

Chart #12 tells us two things: a) commodity prices tend to move inversely to the value of the dollar (i.e., a strong dollar tends to depress commodity prices and vice versa), and b) commodity prices are still pretty high given how strong the dollar is today. Commodity prices do appear to be in a downward trend, following the stronger dollar, and that will reinforce the disinflationary pressures of the Fed's reluctance to cut rates. (The commodity basket I use here excludes crude oil, because it is by far the most volatile of all commodity prices.)

Things could be worse. When the Fed reacted late to the need to tighten policy in 2001, that fueled inflationary pressures, and inflation is a tough beast to wrestle with. Today the Fed is late to the disinflation party, but the consequences—lower inflation and possibly deflation—are not so troublesome. In fact, a return to lower prices in many areas would be cause for cheer among consumers. And it's always a good thing to have a strong dollar rather than a weak dollar, no? Your assets are primarily priced in dollars, so anything that weakens the dollars destroys some of your net worth. By delaying its decision to cut rates, the Fed is boosting the value of the dollar by making owning it more attractive. I can live with that.