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Long-time readers of this blog know that I have been one of only a handful of observers who have linked rapid M2 growth (i.e., money printing) to the big inflation problem that hit the US economy beginning in the first part of 2021. The source of the M2 growth was the government's decision to send out some $6 trillion of checks to the public to compensate for Covid shutdowns and their damaging effects on the economy. At first, most of this money sat idle in consumers' checking and savings accounts as a hedge against great uncertainty and also because consumers had little ability and little willingness to spend it. This amounted to an enormous increase in the demand for money which effectively neutralized the enormous increase in the supply of money. But as life began to return to normal in early 2021, the demand for money declined, and the money was released (monetized) into the economy. Unwanted money fueled a dramatic increase in the price level (otherwise known as inflation).
Fortunately, this problem began fading away more than two years ago, and it continues to do so. Money supply and money demand have returned to more normal levels, and inflation (abstracting from the government's flawed measure of shelter costs) has been 2% or less the for the past year or so.
Regardless, it is still vitally important to monitor money supply and demand. So far, nothing out of the ordinary seems to be happening, and that implies no unpleasant inflation surprises for the foreseeable future. The following charts include M2 as of the end of September, and my estimate for Q3/24 GDP.
Chart #1
Chart #1 shows how the surge in the federal deficit was mirrored by an increase in M2 growth. The link between the two dissolved in the latter half of 2022, with the result that ongoing deficits, though still quite large, are no longer being monetized.
Chart #2
Chart #2 tracks the level of the M2 money supply (currency, retail savings and checking accounts, CDs, and retail money market funds). From 1995 through late 2019 M2 grew at a fairly steady rate of 6% per year, and inflation was relatively low and stable. M2 then surged beginning in April '20 and peaked in early '22. M2 now is only about $1.6 trillion above its 6% trend growth line, and is growing at a modest 3-4% annual rate.
Chart #3
As Milton Friedman taught us, inflation happens when the supply of money exceeds the demand for it. The Fed publishes the M2 measure of money supply once a month. But nowhere will you find a measure of money demand, except here. My measure of money demand is driven by dividing M2 by nominal GDP, which is shown in Chart #3. The best way to understand this is to think of it as the amount of cash and cash equivalents the average person wants to hold relative to his or her annual income. As the chart shows, money demand tends to rise during recessions, and to decline during periods of growth and stability—with the exception of the 2009-2019 period, when it steadily rose.
Money demand soared in the wake of Covid shutdowns, then began to fall as Covid fears faded and the economy revived. It is now only modestly higher than in the pre-Covid period. Money supply and money demand, I would argue, are now back in balance, and that explains why inflation has declined and is likely to remain low.
Chart #4
19 comments:
What do you think of the tariffs that Trump has proposed?
Given the post's title, I was really hoping you'd take on Wesbury's assertions that falling M2 is worrisome and a recession warning. You seem to view it as a healthy mean reversion. He, with seeming disregard for very recent history, views the decline as doomsday, ignoring the heights M2 has to fall from.
A comment or post about your intelligent friend's differing views on M2 decline would be enlightening.
re: "The link between the two dissolved in the latter half of 2022"
I'd say that the link broke because the FED misclassifies O/N RRPs.
Since I sold my house, my rent this year increased by 18%. That's inflation.
I don't think they disagree significantly. Wesbury's recent posts on M2 have observed that if M2 gets too small, it could increase chances of a recession (Doubt Scott would disagree). Wesbury also recently observed that M2 is growing again and, since the Fed ignored that in the past, it could risk re-igniting inflation if they don't ensure their interest rate policies take it into consideration.
https://www.ftportfolios.com/retail/blogs/economics/index.aspx?ID=7654&Print=Y
Re Wesbury's view of M2: I can't explain why he thought a slowdown in M2 from a very high level would cause a recession. I think he just made a mistake that unfortunately has caused him to lose some credibility. Regardless, now he worries much less about M2 because its growth is picking up.
Re Trump's tariff proposals: I'm solidly anti-tariff, and so are most of the people advising Trump on economic policy. The only way to understand this is to view tariffs as a strategic tool. Trump loves tariffs because he can impose them/use them as a threat to achieve other ends. His advisors say their strategy is to "escalate to de-escalate." Threaten tariffs in order to eventually reduce them with the ultimate objective being to improve trade flows and strengthen the US economy. Still, I think they worry too much about China taking advantage of us and so they see tariffs as punishment for China's abusive behavior.
To Salmo about your 18% rent increase: NO, its NOT inflation. It is exactly what it says it is, an increase in rent, which is one item and only that. Inflation is a sustained increase in a BROAD INDEX of prices. I suspect you actually know this and are just making a gasping remark about how much rents have soared.
Libertarian Naivete - often from insulated academics
A couple of topics have been opined on by high level academics over the years, e.g. immigration and trade. Basically, the argument is "open borders" and "no tariffs".
I am a big fan of Professor Friedman, and saw him debate in person once. When he was cornered about what exactly would be an acceptable number of TVs and vehicles that the US could constructively absorb (from Japan), he actually got very humble and said he was but a humble professor and not a businessman.
Similarly, a prominent prof from SoCal is advocating open borders- from the libertarian point of view. These folks have never come up with a number that would be manageable- maybe 7 billion immigrants would be OK?
There are quantitative limits that people who actually have to manage the real world need to work within. It's easy to be a prof or in a similar perch to tout "free trade" and "open borders" if you never have to deal with the consequences.
cycling scholar: The FED artificially suppresses interest rates. As such, the relative value of assets is shifted. Asset prices are most impacted by the pro-rata share of Gresham’s law [a statement of the “principle of substitution” as applied to money: that a commodity (or service) will be devoted to those uses which are the most profitable. It's support for the Cantillon Effect, "effects of inflation on relative prices and the economy"
The “price-level” is not solely representative by (not isochronous with), the consumer’s ever shifting basket of goods and services. When the Fed contracted the price-level, for > 2 years straight, that contraction turned otherwise overvalued safe-assets into impaired ones (upside down or underwater).
Scott, what is your estimate for Q324 GDP?
Any rebuttal on this? What are they overthinking?
“Well, I think as you heard right there, the key line that Paul Tudor Jones said was all roads lead to inflation. I mean, that's what's basically happening right now is that the market is afraid that inflation is not whipped and it's going to resurface, and the Fed may have to pivot from the pivot and raise interest rates. That's why he doesn't want to own any treasuries separately.
Another financial legend, Stan Druckenmiller, gave an interview where he has something like a 20% short position, meaning 20% of his holdings are short US treasuries right now. So he's betting that there are long term inflation pressures and that rates are going to have to rise. And you're seeing again that since the Fed cut rates on September 18th by 50 basis points, that the 10-year T-bills yield has risen by 60 basis points.”
The Federal Reserve was required by the Full Employment and Balanced Growth Act of 1978 to report monetary aggregate growth objectives or targets to Congress. Reporting was done weekly, not lagged.
Grannis knows money matters, but Powell has disavowed monies impact and changed reporting to a monthly delay. Powell has gone so far as to remove the distinctions between transaction accounts and savings accounts by eliminating the 6 monthly withdrawal restrictions on savings accounts.
You know that the FED is lost by looking at the FRED database. It doesn't permit the proper distributed lags of money.
The FED is not tight:
Bank Credit, All Commercial Banks (TOTBKCR)
https://fred.stlouisfed.org/series/TOTBKCR
To bring down inflation the FED has to remain tight today, tomorrow, and for as long as it takes to meet their 2% target.
Salmo Trutta- Yes, if you look at most of the Financial Conditions measures, they are not tight. I wonder if we will get more money supply growth that reawakens higher inflation. Thanks the post.
wkevinw: Higher inflation will come about as the 2-year rate-of-change in money flows reverses to the upside. It will start in the 1st qtr. of 2025.
But I don't see how we are going to keep funding "1 trillion dollars of debt every 100 days"? The O/N RRP facility is now 90% drained.
Demand for money? If people knew what inflation is, there would be much less “demand” for money. And someday maybe they will figure it out.
But everyone has been brainwashed - even the rich - that 2% inflation is part of the normal economics of the world. They kind of know it is b.s. but they don't want to think about it. But that there actually should be deflation! every year - equal to the rate of productivity growth, well that is a whole other matter. If everyone really began to think about it, they would realize that with 4% productivity growth, prices should be falling 4% a year, not being inflated by 4% + 2% “normal” inflation = total 6%!).
But, our country has the Bomb (which we can’t use) and the rule of law (which is fast becoming the rule of the most outraged), so people still “demand” dollars. I believe this “demand” quotient will gradually, or perhaps rapidly, decline and “supply” will rear its ugly head.
Demand may come and go, but supply is forever (unless you really think the Fed is going to reduce their balance sheet)
I really enjoy these posts by Scott Grannis, and have for decades. I think he is right about inflation and the CPI ex-shelter.
BTW, that is the huge issue in the US now: Building more housing.
A huge relaxation of property zoning is needed, maybe even an abolition of property zoning.
Big issue.
Trump’s tariffs are a negotiating tool.
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