Monetary conditions are returning to normal

On June 25th the Fed released the May '24 data for M2 (the release is scheduled for the fourth Tuesday of each month for the previous month's data). There were no surprises.

The M2 story as I tell it goes like this: Beginning shortly after the economy was put into Covid lockdown by overzealous and panicked officials, Washington flooded the economy with some $6 trillion worth of "stimulus" checks in an attempt to mitigate the pain. The public, having no ability or desire to spend this bonanza in an era of extreme uncertainty, allowed the money to accumulate in their bank accounts, thus swelling the M2 numbers but having little impact on the economy. Then, as the economy began to slowly return to normal beginning in early 2021, the public began to spend their bonanza, having little or no desire to let trillions of dollars sit in bank accounts paying little or no interest. Extra, unwanted money began to inflate prices and fuel a return to economic growth. The Fed was slow to realize this, waiting for almost a year to begin (slowly) raising short-term interest rates in an attempt to entice people to hang onto the money. But the damage was done, with the result that the economy was flooded with almost $5 trillion of extra demand (i.e., about 28% more M2 than usual) that enabled the price level to rise by about 20% or so.

Today the economy is once again functioning normally, growing at about a 2% pace. The excess of M2 has been largely worked off, and what remains of above-target inflation is an artifact produced by estimates of shelter costs that seriously lag reality and are questionable at best (see this post for a more detailed explanation). The M2 wave crested two years ago, and ex-shelter inflation has been 2.1% over the past year, well within the Fed's upper limit of 2.5%.

The big inflation episode is essentially over, but the Fed is once again slow to figure this out, and thus reluctant to lower interest rates. Meanwhile, high interest rates have all but crippled the housing market (30-yr mortgage rates at 7% are prohibitive at a time when wages are failing to keep pace with prices). Commercial real estate prices have tumbled over 20% according to figures compiled by the CoStar Group, and there is lots of talk about a coming wave of bankruptcies. Floating-rate loans taken out at 3% interest rates are resetting sharply higher, to the dismay of borrowers already suffering from stagnant real wages. The dollar is king of the hill these days, thanks to world-beating interest rates, but this is squeezing commodity producers as well as the offshore profits of major industries.

To be sure, not all is bad. The Covid lockdowns led to many unforeseen productivity enhancements (e.g., zoom meetings, remote work). The Fed has been reluctant to tighten, so liquidity conditions remain near-optimal. The return of low inflation has boosted confidence. Corporate profits have not disappointed. Credit spreads are low and relatively stable.

Chart #1

Chart #1 illustrates how the almost $5 trillion of "extra" M2 growth has gradually disappeared. The green line extends the growth rate of M2 from 1995 through 2019). Currently, M2 stands only about 9% above where it might have been without the Covid distortions.

Chart #2

Chart #2 shows currency in circulation, which also experienced a burst of growth but has since returned to its long-term trend growth. Currency is a good proxy for money demand, since people only hold currency if they want to—unwanted currency quickly finds its way back to the bank system to be exchanged for interest-bearing deposits. Money demand surged in 2000-2021, but has since returned to "normal" over the past year.

Chart #3

Chart #3 is another way to measure the demand for money, by dividing M2 by nominal GDP. This is a proxy for the amount of liquidity people are comfortable holding as expressed by a percentage of their annual income. Here too we see things are returning to what might be considered "normal," or pre-Covid levels. 

To sum up, the monetary situation has for the most part returned to normal. This lends strong support to the belief that the Fed has essentially managed to once again tame inflation. Interest rates are quite likely to decline going forward, and the only question is one of timing. Meanwhile, the Fed has lots of "dry powder" to unleash (in the form of lower interest rates) should the economy stumble.

The biggest obstacle the economy faces now is fiscal policy, which will depend to a great deal on the outcome of the November elections. Much as I detest Trump's personality and his affinity for tariffs, I strongly believe his policies (e.g., lower tax rates, reduced regulation, smaller government) would result in a stronger economy than if Biden were granted another term in office.

P.S. Sorry for the dearth of posts this month. We spent a lot of time in Argentina recently, where, among other things, we attended the Cato conference in Buenos Aires. There is still tremendous enthusiasm for Milei and his policy prescriptions, but there are concerns that he may delay dollarization for too long. In the meantime he has accomplished much more than anyone would have thought possible in his first six months in office.