Slow M2 means low CPI

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

Chart #4 shows M2 growth (blue line) and the year over year change in the CPI (red line, shifted one year to the left). From this perspective, inflation picked up about one year after M2 surged, and it began to decline a year or so after M2 growth peaked. The red asterisk marks the change in CPI ex-shelter costs, which is, I think, the appropriate measure to watch. The chart further suggests that inflation has fallen pretty much as you would expect, given the decline in M2 growth, and it is likely to remain muted for the foreseeable future.