Abundant reserves enabled a soft landing

In the Old Days (pre-2009), when bank reserves paid no interest—they were considered a "dead" asset—banks held the minimum amount of reserves necessary to collateralize their deposits. When the Fed needed to bring inflation down (usually as the result of a prior mistake that allowed inflation to rise), the Fed restricted the supply of reserves in order to force their price (the cost of borrowing reserves) higher, and to slow the growth of the money supply and bank lending. Higher interest rates and a scarcity of money eventually did the job, but unfortunately, a recession typically followed, heralded by sharply rising credit spreads. 

Around the end of 2008, the height of the financial panic at the time, the Fed made a momentous decision: reserves would become an interest-bearing and default-free asset, and there would be plenty of them. The Fed would control short-term interest rates directly, without having to restrict the supply of reserves. The Fed would pay interest on reserves using funds it received on its holdings of Treasury and mortgage-backed securities, which in turn were purchased by issuing reserves. Reserves effectively became T-bill substitutes, and as such, an ideal asset for the banking system.

At first, most analysts, myself included, feared that an abundance of reserves would result in a surge of lending and higher inflation. Fortunately, that didn't happen. In fact, for the next 11 years, inflation and interest rates would be low and relatively stable. In the first half of 2009 I stopped worrying about abundant reserves becoming inflationary, because I realized that banks had an almost insatiable appetite for holding reserves. The supply of reserves had exploded, but so had the demand to hold them. Thus, abundant reserves were not inflationary.

Then came Covid-19, and panicked politicians shut down the economy. To compensate for the loss of income which followed, Treasury sent roughly $6 trillion in checks to individuals and companies over the course of the next 18-20 months. Initially, most of the extra money sat idle in bank savings and deposit accounts. Then, in early 2021, as the economy began to get back on its feet, people began to spend the money, only to find that supply chains had been disrupted. Demand for goods and services soon outstripped supply, and inflation took off. If Milton Friedman had been alive at the time, he would have realized that his helicopter-drop-of-money analogy had become real: dumping trillions of extra dollars on the economy had ballooned the price level by 20-25%. In early 2021 I began forecasting a serious increase in inflation because I realized that the demand for all the extra money that had been created was beginning to decline.

To its everlasting regret, it took the Fed a year or so to figure out that rising prices were not in fact "transitory," but the real thing. So in March '22 they began the process of tightening by raising short-term interest rates. It wasn't easy to break the back of inflation, because the supply of money (M2) had surged by $6 trillion; they not only needed to reduce the money supply but to persuade (via higher interest rates) people to not spend the money so fast. Meanwhile, pundits and economists of every stripe predicted that, as it always had over the previous 50 years, a recession would inevitably follow the Fed's energetic monetary tightening. Very few, myself included, thought that a monetary tightening that occurred during a period of abundant reserves and ample liquidity would not result in a "hard landing."

To the great surprise of nearly everyone, we have experienced a "soft landing." The Fed has regained control of monetary conditions, inflation has come down to its target, and the economy has managed to grow at a decent rate throughout the tightening process. Abundant reserves arguably were the key. Thanks to abundant reserves, liquidity has been abundant in the financial markets as evidenced by low and relatively stable credit spreads. Financial markets were thus able to act as a shock absorber for the disruption to the economy caused by higher prices and higher interest rates.

Unfortunately, as Milton Friedman famously said, there is no free lunch. Supercharged federal spending has distorted the economy by not only causing inflation, but also by transferring trillions of dollars from the productive sector of the economy to consumers and enlarging the size of the government in the process. Pre-Covid, the federal deficit was almost $1 trillion per year. Currently, the deficit is running at almost a $2 trillion annual rate. Government payrolls have surged at a more than 2% annual rate since early 2023, even as private payroll growth has slowed from 4% in late 2022 to now only slightly more than 1%. Government spending has been the main source of economic growth in recent years, while business investment and manufacturing have been weak. This is not a prescription for solid growth in the years to come. Although real GDP growth in recent years has been about 2.2-2.4% annually, it is likely to slow down in the years to come unless policy shifts in favor of investment rather than transfer payments.

Chart #1

Chart #1 illustrates the gigantic increase in bank reserves that began in late 2008 when the Fed decided to make reserves abundant while also paying interest on reserves. Prior to that, reserves were a direct constraint on bank lending, since banks needed to hold reserves to collateralize their deposits, and reserves paid no interest. QE4 (aka massive Covid-related "stimulus") was the proximate cause of our destructive bout of inflation in recent years. Prior episodes of Quantitative Easing were not inflationary because they were neutralized by strong demand for cash and cash equivalents.

Chart #2

Chart #2 shows the difference between credit spreads on investment grade and high-yield corporate debt. This is an excellent measure of future economic health and financial market liquidity (higher spreads reflect concern about corporate profits and a general shortage of liquidity, while lower spreads reflect optimism about future economic growth and liquidity). Big spikes in credit spreads have reliably predicted recessions. Today, credit spreads are very low, and recession risk is also low—but that doesn't rule out sluggish growth.

Chart #3

Chart #3 shows the level of real economic growth (blue line) and different trend growth rates. The 3.1% annual trend line was in place from the mid-1950s through late 2007, while the 2.3% trend line began in mid-2009. If the economy had followed that 3.1% growth rate following the 2008-9 recession, it would be about 20% larger today.

Chart #4

Chart #4 shows the year over year change in the GDP deflator, the broadest measure of inflation. From a peak of almost 8% it is now only slightly above 2%. This confirms that the Fed has succeeded in controlling inflation. Unfortunately, the price level today is still almost 20% higher than it would have been if inflation had been instead averaged less than 2% per year, as it did in the decade leading up to Covid.

Chart #5

Chart #5 shows the 6-mo. annualized change in the Personal Consumption deflator and its core (ex-food and energy) version. By these measures inflation is also once again under control.

Chart #6

Chart #6 shows the three components of the Personal Consumption deflator. Service prices, dominated by shelter costs, are the only ones rising. Non durable goods prices are almost unchanged for the past two years, while durable goods prices have been declining for two years. Deflation in the durable goods sector has returned.

Chart #7

Chart #7 is a reminder that every recession prior to the Covid recession was the result of tight monetary policy. Monetary policy was tight because real interest rates were very high and the Treasury yield curve was inverted. Those two conditions have returned of late, but there is no recession in sight. What's different this time? Abundant reserves.

Chart #8

Chart #8 shows the ISM purchasing managers survey of the manufacturing sector. This has been notably weak since late 2022. That the economy has grown by almost 3% in the past year is due almost entirely to government spending and transfer payments. 

Chart #9

Chart #9 shows the monthly change in private sector payrolls over the past 3 years, as well as the rolling 6-mo average of same. In early 2022, payrolls were growing by about 600,000 per month; now they are growing by only 100,000 per month. (I assume the very low number for October to be the result of hurricanes, strikes, and random variations which can and do happen quite often.) While this is not necessarily a precursor of recession, slow jobs growth does point to a loss of vitality in the economy which could persist and/or worsen. We are not likely to see 3% GDP quarters on a sustained basis; be prepared for 2% or less. At least that will make it easier for the Fed to continue to cut interest rates.

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. 

The enormous net worth of the US private sector

This post extends a series of similar posts I've made over the past 15 years. It highlights the net worth of the U.S. private sector: the net value of assets and liabilities of individuals and non-profit organizations.  As of June '24, the total net worth of the U.S. private sector was $164 trillion, and the net worth of the average person living in the U.S. was almost half a million dollars. 

Does the proliferation of billionaires distort the picture? Not much. According to Forbes, at last count the U.S. had 2,800 billionaires, whose net worth totaled in the range of $17-20 trillion. The net worth of the Forbes Top 400 billionaires totaled $5.4 trillion. If we exclude all billionaires from the total, the net worth of the average American would be about $425K, which is still pretty impressive.

Chart #1

As Chart #1 shows, private sector net worth has increased by 167% over the past 20 years, and now stands at $164 trillion. The biggest gains have come from financial assets (stocks, bonds, and savings accounts), which have increased 149%. Real estate assets have increased 144%, while liabilities have increased a mere 44%. The federal government is heavily indebted, but not so the private sector! 

Chart #2

Chart #2 shows the real, inflation-adjusted value of private sector net worth. Net worth peaked at 166.7 trillion in December '21, and has since declined to $164 trillion. The rather spectacular gains of the stock market and housing in recent years have been diluted by inflation. Still, real net worth is still on a rising path, averaging gains of about 3.6% per year.

Chart #3

Chart #3 divides real net worth in Chart #2 by the U.S. population (about 342 million). Real per capital net worth peaked at $509,500 in 12/21, and fell to $481,000 through June of this year, due to the effects of inflation and an increasing population. Still, it has risen on average by about 2.4% per year. If this continues, by 2054 the average American will be worth $1 million in today's dollars.