M2 update: still looking like inflation will remain low

Here's an updated look at key charts and indicators that I have been following for the past several years. All continue to suggest that inflation is likely to remain relatively low. Moreover, whereas the economic outlook had been looking rather modest, there are now welcome signs of an economic pickup on the horizon; this builds on the fact that corporate profits have been quite healthy of late. 

Chart #1

Chart #1 shows the growth of the M2 money supply, which is generally considered the best one to follow. For the past 3-4 years I've noted that the Covid-related "bulge" in M2 was disappearing, and that is still the case. The relationship between money and nominal GDP has almost returned to where it was pre-Covid. Recall that from 1995 through 2019 M2 grew at a 6% annual pace, while the CPI averaged about 2%. 

Chart #2

Chart #2 shows the 6-mo. annualized change in M2. Currently at 4.7%, it is still comfortably below 6% and shows no signs of any worrisome uptick. The Fed lost control of M2 from 2020 through 2021, but it has been back in control for the past several years.

Chart #3

Chart #3 illustrates what I call "money demand." It is the ratio of M2 to nominal GDP, and can be thought of as the amount of risk-free money and money equivalents that the average person or corporation wishes to hold, expressed as a percentage of annual income. Here we see that money demand is almost all the way back to its pre-Covid level. A powerful increase in money demand drove the ratio higher from 2020 to 2021, and an equally powerful decline in money demand (which in turn has been driven by a decline in risk aversion) has driven the decline in the ratio since 2022. Money demand appears to be stabilizing at a time that money supply is growing at a relatively slow pace. This argues strongly for there being an absence of any monetary source of rising inflation. Higher oil prices are certainly driving energy-related prices higher, but this is not symptomatic of an untoward rise in the general price level. I suspect that the longer oil prices remain elevated, the more stories we will hear of price declines in other areas of the economy. The economy's monetary "budget" does not allow for an overall increase in prices beyond what we have been seeing in recent years.

If anything, the war in Iran is more likely to increase the public's demand for the safety of money and money substitutes. In the absence of any acceleration in the supply of money, it is very hard to make the case that inflation overall is going to rise.

Chart #4

Chart #5

Capital goods orders are good evidence of corporations' willingness to invest in new plant and equipment (and software, aka artificial intelligence these days). Chart #4 uses a 3-mo. rolling average of monthly order levels for nominal and real values, whereas Chart #5 shows the actual monthly nominal values. Note how strongly orders have increased of late (Chart #5). This is big news, and strongly suggestive of a stronger economy in the years to come.

Chart #6

Not all is rosy, however. Chart #6 shows real and nominal nationwide housing prices (the index measures average prices in the three months leading up to the reporting period, so it is somewhat lagging the reality today). Real prices have been flat for several years, and nominal prices are up only 0.7% in the past year. This sure looks toppy to me.

Many millions of people own their homes, and these days they are paying a pretty penny to do so. One look at this chart tells you that home price appreciation has dropped to almost zero. Taking inflation and interest rates into account, owning a home is not only expensive (e.g., property tax, insurance, and mortgage interest) but also extremely burdensome. 

If you are paying over 6% to finance an asset that is not going up in price (and may soon go down), you are leveraged into a losing bet. Even if you have a 3% mortgage, the opportunity cost of money these days is closer to 5 or 6%. A "conservative" home purchase made with a 20% down payment and a 6.25% mortgage today equates to using 5-to-1 leverage. So the expected return today of owning or buying a house is approximately 6% less than what it is costing you, multiplied by a factor of 5 if you are using leverage to own it. If home prices stay flat for the next few years, you will be losing roughly 30% (6% times 5) of your down payment each year. (OK, for those who can deduct mortgage interest it's not quite so bad, but still ... and don't forget insurance—which has become extremely costly if unattainable for many—plus property taxes and maintenance.)

This is not a pretty picture.

Chart #7

Chart #7 shows the housing picture in a different light. Here we see that housing starts have been stagnant to somewhat lower for the past several years, and homebuilders are not very optimistic at all that things are going to get better. Plus, home sales have been very weak for years. Strong demand for housing coupled with a limited supply has forced prices higher, but that dynamic is running out of steam. Leverage worked to buyers' advantage from 2013 through 2021, but now the tables have turned. Things won't get better until mortgage rates decline meaningfully and/or home prices decline.

Chart #8

As Chart #8 reminds us, thanks to the BLS's method of calculating owners' equivalent rent, the OER contribution to the CPI is beginning to subtract from reported CPI inflation.

GDP update (4/30/26): the economy grew at a moderate 2.0% annualized rate in the first quarter. As the chart below shows, the economy has been growing at about a 2.3% annualized rate ever since the middle of 2009 (i.e., the end of the Great Recession). 

Chart #9

The green line is an extension of the trend that prevailed from the mid-60s through 2007. If the economy had followed that path, it would be 24% larger today. We've had 17 years of sub-par (by historical standards) growth. Let's hope that Trump's efforts to trim tax and regulatory burdens, coupled with the "magic" of Artificial Intelligence can boost our future growth path. 

Big Picture charts: modest growth and low inflation

Here are 5 charts which illustrate some very important points about the state of the economy and the outlook for inflation. 

The economy is doing "Ok", but it's nothing to write home about. The housing sector is struggling mightily, and is very unlikely to improve without a boost from lower interest rates. Jobs growth is modest at best, and unlikely to improve without immigration reform which prioritizes making hard-working illegals legal instead of deportable. 

There is no longer any doubt that the Fed has tamed inflation.

Given low inflation and an economy that is struggling, there is no reason for the Fed to delay lowering interest rates. Trump is right to criticize Chairman Powell for this, but Trump could help by backing off on his egregious tariff demands and his aggressive deportations of illegals, most of whom are decent, hard-working, and tax-paying members of society. He should focus instead on lowering tax and regulatory burdens and greatly expanding immigration quotas.

Chart #1

Chart #1 is yet another update of a chart I've been featuring for the past 15 years. The green line represents the 3.1% annual growth path the economy followed from 1966 through 2007. During that time, the economy was able to rebound and regain that growth path after every recession (this is commonly referred to as the "plucked string" theory of growth). Since the end of the Great Recession in mid-2009, the economy has only managed to follow a 2.3% annual growth path (red line). If the economy had instead recovered to a 3.1% growth path it would be 23% bigger today. I've attributed this monstruous growth shortfall to increased tax and regulatory burdens and a sizable increase in transfer payments. (See my post from 11 years ago which explains this in greater detail.)

Chart #2

Chart #2 compares the year over year growth rate of private sector jobs (red line) with the year over year growth rate of real GDP (blue line). It stands to reason that without more people working it's hard for the economy to expand. Currently, jobs growth is only slightly higher than 1%, and the economy has expanded by only 2% in the past year. That 1% difference is a good approximation of productivity growth, which is less than the 1.9% annualized rate of productivity since 1966. If jobs growth doesn't pick up (and it won't if we are deporting millions of hard-working illegals), then the economy is going to continue to grow at a sluggish pace. 

Chart #3

Chart #3 compares the level of housing starts (blue line) to an index of homebuilders' sentiment (red line). There is only one interpretation: the outlook for the housing market is gloomy. Housing affordability is at all-time lows (due to the combination of high prices and high interest rates), and the inventory of unsold homes is relatively high and rising rapidly. I'm hearing talk that construction sites around Southern California are having trouble getting workers to show up—they are mostly Mexican and many are likely illegally here. Everyone is afraid of ICE raids. 

Chart #4

Chart #4 shows the year over year change in the Personal Consumption Deflators (total and core). Although both are somewhat above the Fed's target range, a closer looks says they are well within it. In the past three months (March, April, and May), the annualized rate of growth of both these inflation measures has plunged to 1.1% (total), and 1.7% (core). Powell's favorite measure, PCE core services less shelter, is up at a mere 1.1% annualized pace in the past 3 months. Note: these same three months include the impact of Trump's higher tariffs—which is to say that higher tariffs have not resulted in higher inflation by any measure. This is what I and many others predicted.  

Chart #5

Chart #5 shows the three components of the PCE deflator: services, durable goods, and non-durable goods. As should be obvious, goods prices have been flat to down for the past 3 years. Inflation is only to be found in the services sector, and shelter costs make up a large portion of that sector. Lower housing costs are going to be depressing services inflation for a long time. The Case/Shiller index of national home prices peaked earlier this year and has fallen at an annualized rate of 1.8% in the most recent 3 months. Add it all up and the outlook for inflation is LOW for the foreseeable future. I think the Fed is getting very close to realizing this, so we will soon have lower interest rates and that should help.

Despite this somewhat downbeat, near-term outlook, I remain reasonably confident that we can avoid a disaster and the economy can improve with time. Trump has been a wrecking ball in many ways, which is unfortunate, but in the process he has provoked a lot of thought and shaken up things that needed to be shaken up (corruption and waste in the federal government, immigration, trade barriers, to name just a few). Between the Abraham Accords and the targeted bombing of Iran's nuclear sites, he may well have transformed the future of the Middle East for the better. 

Near-term gloom, long-term boom

Sorry for my prolonged absence. I had some minor health issues that are now behind me, and more recently I've enjoyed a few weeks skiing at Deer Valley with my brother. What's really kept me off balance, though, is the blizzard of executive orders emanating from the Trump White House—most of them good, but some—particularly punitive tariffs—bad for growth. Trump can't change so many things without causing near-term problems, even if the long-term result is undeniably positive. So I struggle to understand how serious the negative fallout of cutbacks, firings, and tariffs will be over the near term, as compared to the hugely beneficial effects of sharply reduced tax and regulatory burdens over the long term and how both those factors will play out in the months ahead. For that matter, I doubt whether anyone has a clear view.

As we continue to try to parse the daily barrage of news, there are disturbing signs that the economy has entered a weak patch. The Atlanta Fed's GDP Now model is forecasting Q1/25 growth to be a very disappointing -2.8%, driven primarily by the assumption of an import surge driven by attempts by businesses to avoid future tariffs. The housing market is fragile and housing starts are weak because prices are high and interest rates are high, and the combination renders housing unaffordable for most. Loan delinquencies are still relatively low, but clearly rising. Business capital spending has stagnated for years, but shows some signs of life of late. Meanwhile, tariffs—which are equivalent to a tax hike, and as such will disrupt sectors of the economy to some degree—are increasingly taking center stage, enough so to keep the market and the economy off balance. Private sector jobs growth is modest, while public sector jobs growth will certainly weaken thanks to DOGE house cleaning. The dollar is quite strong, and that is keeping pressure on commodity prices. The Fed is reluctant to ease further because they feel Trump's tariffs could be inflationary, and they are unwilling to overlook the fact that the CPI is a little on the high side mainly because of the way shelter costs are measured.  

On the positive side—and this has been a big positive for a long time—liquidity conditions are healthy and credit spreads remain quite low. It's hard to overstate how important it is for financial markets to be free of the liquidity squeeze which has accompanied every Fed tightening episode prior to the current one. Banks are flush with over $3 trillion of reserves, instead of being forced to bid for scarce reserves. Credit markets are thus well-oiled and able to fulfill their role as a shock absorber for the physical economy; risk is able to be distributed from those who don't want it to those who do, and that is a big positive. Meanwhile, real interest rates on 5-yr TIPS have dropped by an impressive two-thirds of a point so far this year. This foreshadows a meaningful relaxation of monetary conditions which will help ease the pain in the housing and commodity markets—but not soon.

Stepping back from markets and the economy, I see a serious potential threat in the cryptocurrency space. Speculative fever is raging, turbo-charged by the belief that Trump will buy a mountain of bitcoin for a U.S. reserve stockpile—a move I consider foolish to the extreme. Some amazing statistics: there are over 10,000 different crypto currencies that now have a total market cap of $2.95 trillion, down some 20% from an all-time high of $3.72 trillion in mid-December. Bitcoin dominates, representing about 60% of the total.  No one has the slightest idea of the inherent or intrinsic value of crypto currencies, so their price is driven solely by speculative ebbs and flows. Did you hear about the guy who lost a hard-drive containing $775 million worth of bitcoin and has no hope of recovering it?

A series of charts follow that help illustrate some of the above points.

Chart #1

The M2 measure of the money supply is the most important financial variable that almost no one (including the Fed) pays any attention to. (I have been reporting on M2 ever since this blog started back in 2008.) By now everyone knows that the big inflation we suffered in 2021 and 2022 was caused by a $6 trillion explosion in the M2 money supply, which in turn was fueled by $6 trillion of federal stimulus checks that were effectively monetized. 

As Chart #1 shows, M2 today is only about $1.5 trillion above where it would have been if nothing extraordinary (like Covid) had happened. From 1995 through 2019 M2 grew by about 6% per year, and inflation was not a problem. M2 is now almost back on track, and inflation is no longer a problem. The Fed has tightened enough, and most of the excess money that was printed has been absorbed by the economy. This is very good news from a monetarist perspective; without excess money there can be no rise in inflation. 

Chart #2

Chart #2 tells the part of the monetary story that almost no one hears: the demand for money, expressed as the ratio of M2 to nominal GDP. When the money supply exploded in 2020 and early 2021, it wasn't inflationary because the demand for money also exploded—people let the checks sit in their bank accounts because of great uncertainty and the inability to do anything. But beginning in early 2021 the demand for money started to decline as economic life began to return to normal, and that meant the economy was suddenly holding a lot more money than desired. People began to spend that money in earnest, despite supply bottlenecks, and that quickly resulted in higher prices. Today the demand for money is almost back to where it was pre-Covid and it appears to be stabilizing, plus bottlenecks have disappeared.  

Chart #3

Chart #3 shows the trade-weighted and inflation-adjusted value of the dollar vis a vis two baskets of other currencies. By either measure, the dollar today is quite strong from an historical perspective. A strong dollar is a good thing: 1) it confirms the absence of excess money, 2) it reflects confidence in the Fed and the economy, and 3) it keeps prices of imports relatively low. From a macro perspective, a strong currency is the very antithesis of inflation. 

Chart #4

Chart #4 shows one reason the dollar is strong: real yields (the yields that really count) are relatively high. Real yields in turn are a good barometer of how tight monetary policy is. High real yields reflect tight money and they make owning the dollar attractive because they enhance the real return on holding dollars.

Chart #5

Chart #5 shows that commodity prices tend to move inversely to the value of the dollar (note that a rising blue line represents a falling dollar and that tends to correspond to rising commodity prices). In recent years that relationship has weakened, but it still looks to me like a strong dollar is exerting downward pressure on commodity prices. 

Chart #6

Chart #6 shows the real (inflation-adjusted) price of gold from 1947 (when it was about $35/oz.) through today. I've used the Consumer Price Index to calculate how much in today's dollars it would have cost to buy gold at different times in the past. Note the enormous volatility of real gold prices. From a high of over $2,500/oz in late 1980, real prices subsequently fell to a low of $470 in early 2001—a decline of over 80%. Today, real gold prices are at all-time highs.

A century ago, an ounce of gold cost a little less than $21. Since then, the gold price has risen by 13,800%, to $2,925/oz. as I write this. Over that same hundred years, the Consumer Price Index has increased by 1,755%, which means the real price of gold has increased by 670%, or about 2% per year. Yes, gold tends to hold its value over time, but sometimes it takes a lifetime for that to be true. 

Chart #7

Chart #7 compares the dollar to real gold prices. Here we see that from 1997 through late 2022 gold has shown a strong tendency to rise as real yields fall and to fall as real yields rise (note that real yields are plotted on an inverse scale), and vice versa. That makes sense because high real yields are a compelling alternative to owning gold, because TIPS not only preserve purchasing power but they also offer positive income, whereas gold only sometimes preserves its purchasing power and pays no income. But in the past several years the opposite has happened: gold has risen as real yields have risen! 

That gold, bitcoin and the dollar today are all historically strong, at a time when real yields are relatively high and the dollar is strong, demands a closer look. In theory, gold should rise in dollar terms as the value of the dollar falls, and gold should fall in dollar terms as the dollar rises. Meanwhile, the dollar tends to rise as real yields rise. 

Chart #8

Turning to the economy, Chart #8 shows two measures of the growth rate of private sector jobs. Jobs growth has weakened significantly in recent years, and is now only slightly more than 1% per year. 

Chart #9

Chart #9 compares the year over year change in the CPI to the CPI ex-shelter costs. If one agrees that shelter costs as per the government's calculation are overstated, then the CPI has been at or below the Fed's target of 2% since mid-2023.

Chart #10

Chart #10 shows the nominal and inflation-adjusted value of national home prices since 1987. Real home prices are at all-time highs by a clear margin, but they haven't increased for the past several years. 

Chart #11

Chart #11 compares 30-yr fixed mortgage rates to an index of new mortgage applications, which are a proxy for home sales. Home sales and new mortgage applications have been severely depressed for several years now, most likely because of very high mortgage rates.

Chart #12

Chart #12 combines the price of homes with the level of interest rates and average incomes to calculate how affordable homes are. Housing affordability has almost never been so low, and that explains the dearth of home sales, housing construction, and new mortgage applications (see Chart #13 below). 

Chart #13

Chart #13 compares an index of builder sentiment to the level of housing starts. Builder sentiment has been depressed for several years now, likely because of how unaffordable homes are. Until this improves, the level of housing starts is likely to remain depressed as well. That in turn will only aggravate the picture, since a dearth of new homes will tend to put upward pressure on housing prices. The solution to this must come in the form of lower interest rates and/or rising incomes and/or lower home prices.

A final thought: a reasoned calculation of the amount of federal, state, and local government fraud approaches the staggering sum of $1 trillion per year. Meanwhile, I can't pretend to know how the blizzard of activity in Washington is going to affect the economy over the next 3-6 months. We could easily see a mild recession, but would that justify a bearish investment stance? 

I remain an inveterate rational optimist: there are so many things that could be fixed for the better in this country!

Happy Hunting, Elon!

Tariff fears trump modest jobs growth

Today's December private sector jobs report beat expectations (223K vs. 140K) and that supposedly triggered a sharp, negative response from the bond market. Interest rates are now priced to only one more cut in the Federal funds rate for the rest of this year. As a result, in the past few months short-term interest rates have jumped by almost one percentage point, 10-yr Treasury yields have jumped by more than one percentage point, and 30-yr mortgage rates have risen to almost 7%. 

But the perceived health of the jobs market wasn't the only thing that rattled the bond market today. Another contributing factor was the Fed's fear (shared by the market) that Trump's threatened tariffs would boost inflation, as revealed in the minutes of the last FOMC meeting. From mid-August, when Trump's probability of winning the election bottomed, 5-yr average inflation expectations have jumped from 1.87% to 2.54%. In any event, it remains the case that inflation is not caused by a stronger jobs market or stronger economic growth: growth has soundly beat expectations in recent years even as inflation has declined significantly.

 

Whatever the cause, higher rates and higher inflation expectations effectively put the kibosh on hopes for lower mortgage rates, and thus will likely worsen the prolonged period of historically weak home sales, housing starts, and new mortgage applications which began over two years ago. Sadly, it will add insult to the injury of many thousands of displaced Los Angeles area residents seeking to rebuild or replace homes lost to multiple fires.

As I see it, the rationale for today's sharply higher rates and slumping stock market has weak underpinnings: the mistaken belief that tariffs will boost inflation and thus require tighter-than-expected Fed monetary policy. 

Chart #1

Chart #1 shows the monthly change in private sector payrolls over the past 3 years. Note how volatile this statistic is on a month-to-month basis; that anyone—especially the Fed—would use just one month's number as a basis for important long-term policy decisions strains credulity. But that's what happens every now then, with today being a prime example. 

Chart #2

Chart #2 uses a more realistic approach to interpreting the state of the jobs market, by focusing on percentage changes in jobs over 6- and 12-month periods. By either measure there has been a dramatic slowdown in jobs growth in recent years. At best, jobs currently might be growing at a 1.3% annual rate, which is marginally lower than the 1.4% annualized rate that has prevailed over the past 30 years (a period that includes three recessions). Current jobs growth is moderate at best.

Chart #3

Chart #10 shows the level of 10-yr Treasury yields, which is the benchmark for all long-term interest rates (including fixed-rate mortgages). Simply put, interest rates have exploded higher in recent years. Only abundant liquidity has kept this from tanking the markets and the economy. (For a longer explanation, see this post from last November.)

Chart #4

Chart #4 compares the level of fixed rate mortgages to an index of new mortgage applications (as opposed to mortgage refinancings). The plunge in new applications reflects a similar plunge in new home sales and housing starts. In effect, sharply higher rates have crushed the housing market. 

Chart #5

Chart #5 compares the level of real yields on 5-yr TIPS to an index of the dollar's strength vis a vis other major currencies. Rising real yields are an excellent measure of how tight monetary policy is. Not surprisingly, tight money and high real yields have significantly boosted the dollar's appeal. A strong dollar positively impacts our purchasing power while also keeping imported goods prices low; indeed, a strong dollar is an excellent defense against inflation, especially when accompanied by tight monetary policy. 

Chart #6

As I mentioned in my last post, a strong dollar puts downward pressure on commodity prices. Indeed, industrial commodity prices have declined in both real and nominal terms over the past two years, as shown in Chart #6, thanks to a strong dollar.

Monetary policy is tight and has become tighter of late, as the market and the Fed worry about the presumably inflationary impact of Trump's tariffs that have yet to be imposed. It makes much more sense to believe that Trump's promises to significantly lower tax and regulatory burdens will deliver stronger growth with low inflation.

Charts that call my attention

There's no unifying theme to this post. It's just a collection of charts which I find interesting, some reflecting positive developments, others suggesting caution.

Chart #1

Chart #2

Chart #1 compares the year over year change in the CPI with the ex-shelter version of same, which makes up about ⅓ of the total CPI. Of note, the ex-shelter change in the CPI has been 2% or less in 13 of the past 16 months. If you believe, as I do, that the BLS's method for calculating housing/shelter inflation is flawed, then that means the Fed managed to tame inflation well over one year ago. As I've shown in previous posts, it looks like shelter costs, which drive ⅓ of the CPI, are based on the year-over-year change in US housing prices from 18 months ago; that is the only reason the overall CPI has not fallen below 2%. Chart #2 illustrates this. In the past year or so, housing prices have increased at a much slower rate.

Chart #3

Chart #3 compares industrial production levels in the U.S. and Eurozone. There are several remarkable things going on here. For one, U.S. industrial production levels haven't increased at all over the past decade! Two, Eurozone industrial production is tumbling in a way that suggests recessionary conditions. One reason for this is Germany's obsession with renewable energy sources at the expense of cheap and reliable natural gas and petroleum. Germany's electrical grid is seriously compromised as a result, and electricity costs have skyrocketed. Read all about it, courtesy of Robert Bryce, the best energy analyst I know. 

Key takeaway: the goal of renewable energy is a pipe dream, and seeking it out is kneecapping electric grids and retarding economic progress everywhere, penalizing the poor to satisfy the preening elites who will apparently make any sacrifice in the name of quixotically saving the planet. Cracks in the green energy coalition are already forming in Holland, and this seems sure to spread to other countries in coming years.

Chart #4

Chart #4 makes it clear that housing construction is depressed. Housing starts have been falling for the past two years, and builders see little hope in sight for improvement.

Chart #5

Chart #5 shows why housing is depressed. Mortgage rates have soared in recent years, and new mortgage initiations have plunged and stagnated. Very few can afford to buy homes given sky-high prices coupled with nearly 7% interest rates on mortgages. At the same time, very few homeowners want to sell, since it would mean giving up their 3% mortgages. This is an unstable situation that will eventually be resolved by falling home prices and/or falling mortgage rates.

Chart #6

Chart #6 compares the strength of the dollar (blue line, inverted), with an index of non-energy industrial commodity prices in constant (real) dollars. Up until a few years ago, commodity prices were strongly and inversely correlated with the strength of the dollar (i.e., a stronger dollar tended to depress commodity prices while a weaker dollar tended to boost commodity prices). This relationship broke down starting in early 2021 when inflation began to rise. I suspect that restrictive monetary policy will eventually restore this correlation—meaning commodity prices face downward pressure.

Chart #7

Chart #7 is constructed in a similar fashion to Chart #6, but instead of commodity prices it shows real gold prices. Commodity prices fell sharply beginning in early 2022, but gold prices started to soar in late 2023 in the wake of the Hamas attack on Israel. Unlike virtually all other commodity prices, gold prices have been making new all-time highs (on both a nominal and inflation-adjusted basis) ever since. I think the conclusion is obvious: geopolitical tensions in eastern Europe and the Middle East are close to red-hot. Gold is acting like the ultimate port in a storm that threatens another world war. Steven Hayward describes the mess we're in succinctly. Another thing this chart shows is that the dollar is relatively strong and strengthening of late; both the dollar and gold are benefiting from their status as safe-haven assets. 

Chart #8

I've been fascinated by the decade-long decline in small cap stock prices relative to large cap stock prices. On a total return basis, the S&P 500 index has more than doubled the return on the Russell 2000 index over the past decade! Chart #8 helps illustrate this, while also suggesting that the Fed's monetary policy tightening and easing cycles has had something to do with this. 

The blue line in this chart is the ratio of the Russell 2000 Small Cap Index to the S&P 500 Index. The red line is the inflation-adjusted (real) level of the Fed funds rate, which in turn is the best measure of how tight or how easy the Fed's monetary stance is (inverted to show that a rising red line corresponds to easier monetary policy and vice versa). It's not a perfect correlation, but it seems that Fed easing (which usually comes in the wake of economic weakness) inevitably leads to small cap stock outperformance. By now it's clear the Fed has embarked on an easing cycle. With Trump's policies promising a significant reduction in regulatory burdens (which would help smaller companies much more than larger companies), I think we may therefore be at the beginning of a period of small cap outperformance.

Chart #9

Chart #9 shows the astonishing outperformance of US equities vs. Chinese equities over the past 30 years. (Both y-axes have a similar ratio scale, and both are plotted on a logarithmic basis). China's economic model has failed utterly to compete with ours.

Charts with a message

The US economy grew 3.1% last year, trouncing widespread calls for a recession and exceeding my relatively sober expectation for 2% growth. With growth apparently persisting this year, and with popular inflation numbers marginally higher than the Fed's target, both the market and the Fed now question whether and by how much the Fed should cut rates. The prevailing market wisdom holds that the Fed will cut rates once before year end; they might move sooner, however, if the economy shows clear signs of slowing down and year over year inflation falls below 2%.

I continue to argue that the Fed has essentially reached its inflation target. M2 money growth has been flat to negative for two years, and inflation ex-shelter costs (which are artificially inflated due to the BLS's faulty measurement) has declined to the Fed's target. Moreover, today's interest rates are high enough to almost paralyze the housing market, high enough to keep the dollar strong, and that in turn is enough to depress most commodity prices. Fortunately, credit spreads are still quite low, and, when combined with plentiful liquidity, it's not hard to conclude that monetary policy is not tight enough to precipitate a recession.

The correct way to view the interplay between growth and inflation is to first understand that high inflation is bad for growth, while low and stable inflation is conducive to growth. Economic growth by itself does not cause inflation—only monetary policy does. As my mentor John Rutledge explains it, inflation is like fog on the highway; it forces everyone to slow down because of a lack of visibility. Inflation creates uncertainty about the future value of the dollar, the level of interest rates, and prices. Reducing inflation thus eliminates uncertainty and promotes investment, which in turn drives growth. In short, the economy grew so much last year because inflation fell. 

The charts which follow have several messages: 1) interest rates are high enough to cause some serious problems in the housing market, while at the same time boosting the dollar and keeping downward pressure on commodity prices, and 2) some sectors of the economy—manufacturing, international trade, small businesses, commercial real estate, and the service sector in general—are struggling even as the high tech sector continues to boom and corporate profits are showing healthy growth (which is why the stock market is moving higher).

Chart #1

The average rate on mortgages held by the public is 3.9% or so, whereas the current mortgage rate for new 30-yr loans is 7.2%. This creates a powerful incentive to avoid selling one's home, because acquiring a new mortgage is extremely expensive. It also depresses the demand for housing because 7.2% mortgage rates make home prices quite unaffordable for the vast majority of people. Housing supply and demand are both very constrained, with the result that the market is not likely in an equilibrium situation. Conditions could change dramatically at any time.

Chart #1 also shows that the spread between mortgage rates today and 10-yr Treasuries (the backbone of the mortgage market) is elevated. Why? Because investors are reluctant to buy 30-yr mortgages that could turn into very short-term interest rate loans should Treasury yields decline (because those who borrow at today's high rates would rush to refinance if rates fell). In sum, homeowners don't want to sell, buyers don't want to buy, and lenders (investors) don't want to lend. Again, this is not a healthy market and these conditions cannot persist much longer. 

Chart #2

As Chart #2 shows, housing hasn't been so unaffordable for many decades. 

Chart #3

Chart #3 shows that the volume of new mortgage applications is at very low levels, having dropped by roughly 75% since the heydays of 2005-2006. 

Chart #4

As Chart #4 shows, and as is consistent with the big decline in new mortgage applications, the volume of home sales is very low from an historical perspective. 

Chart #5

As Chart #5 shows, housing starts are weak because builders are not confident that the outlook for the housing market is healthy. Modest growth in home construction will not be a source of stronger overall growth. What is clear is that the housing market needs a significant decline in interest rates in order to improve.

Chart #6

As Chart #6 shows, industrial production in the US has been flat for several years. Meanwhile, industrial production in the Eurozone is suffering from recessionary conditions. The US economy is the global economy's primary engine of growth these days, but it is not very impressive.

Chart #7

World trade volume (Chart #7) surged from 2000 through 2019, but has since stagnated. Geopolitical tensions undoubtedly explain most of this, but without an increased pace of trade the global economy is lacking a key engine of growth. Heaven help us if war spreads to Europe and throughout the Middle East. 

Chart #8

As Chart #8 shows, small business optimism is very low. Small businesses are essential to the overall health of the economy, so this is a troublesome sign. Likely culprits: increasing regulatory burdens, high inflation, high tax burdens, green energy subsidies which incentivize unproductive investment, geopolitical tensions, and the political polarization which increasing divides the economy.

Chart #9

Chart #9 shows that commodity prices have a strong tendency to move inversely to the strength of the dollar. (The dollar is plotted on an inverse y-axis, so a falling blue line means a stronger dollar.) What stands out here is that commodity prices are unusually strong relative to the dollar. But their ability to rise appears to be constrained given the dollar's ongoing strength. 

Chart #10

Chart #10 tells us that the dollar's strength owes a lot to the fact that US interest rates are much higher than those in Europe and the rest of the developed world (the blue line represents the spread between 2-yr US and German yields). Stronger US growth and more attractive yields combine to enhance the appeal of the dollar vis a vis other currencies. This is turn helps depress commodity prices, which also helps to restrain inflation. 

Chart #11

Chart #11 tells us that the commercial real estate market is facing serious problems. On a value-weighted basis, commercial property prices have fallen 20% from their July '22 high. By the same measure, office property prices (not broken out here) have fallen 34.5% from their all-time high.

Chart #12

Chart #13

Chart #12 suggests that business activity in the service sector of the economy (by far the largest sector) has fallen significantly of late. Chart #13 shows that that less than half of service sector businesses plan to increase the number of jobs. By this measure, the service sector could be experiencing recessionary conditions. It also reinforces the message of Chart #8 (small business optimism), and together the two tell a troubling story.

Chart #14

Chart #14 shows the year over year change in the number of private sector jobs according to the establishment survey. (Private sector jobs are the only ones that really count, in my opinion.) Jobs are growing at a relatively moderate 1.7% annual pace, which is nothing to get excited about. If this were to continue, it would probably be enough to sustain an overall pace of growth for the economy of about 2.5% - 3.0% per year—which is at odds with all the charts above that tell of weakness. What stands out here is the rather significant deceleration of jobs growth since the beginning of 2022. This is not a boom, but neither is it a bust. Yet.

Chart #15

Chart #16

Chart #15 is an updated version of a chart I have been featuring for months. What it says is that if it weren't for the way the BLS computes housing prices (which is based on the year over year change in housing prices 18 months ago), inflation today would be within the Fed's target range today. (The Fed is targeting 2% inflation in the Core Personal Consumption Deflator, which is equivalent to about 2.5% in the CPI, because the CPI tends to exceed the deflator by roughly 0.5% per year.)

Chart #16 all but proves that the BLS uses ancient housing prices to compute today's rate of shelter inflation. The red line has been falling almost exactly in line with the yoy change in housing prices 18 months ago. If this relationship holds, then the red line will fall from 5.8% today to about 2.5% by October, and this would in turn subtract a significant amount of shelter inflation from the overall CPI. 

On balance, I see the risks pointing to weaker rather than stronger growth, and lower rather than higher inflation. If the economy weakens, interest rates are quite likely to fall, and that will reduce the threat of further weakness. I think the stock market sees this as well, in the form of what is called a "Fed put," or what is akin to a hedge against recession.