Tuesday, January 31, 2023

Recommended reading: Steve Moore's Hotline

I've known Steve Moore since the 1980s, and he's one of the best economists out there, especially when it comes to understanding and explaining the relationship between government policies, the economy, and what creates prosperity. For several years now he has been publishing a daily Hotline newsletter that is always full of must-know facts and figures. And it's free, just for the asking.

Today’s edition features Chart #2 from my last week's post. I used the chart to make the point that bad economic policies have resulted in very slow growth for the US economy for the past 14 years. He translates that into a number that people can more easily relate to: "if we had stayed on the 1984-2004 growth path, the average American would be about 22% richer today – or at least $15,000 more income per median income family."

Once again I would encourage all to subscribe to the Hotline.

Thursday, January 26, 2023

GDP up, inflation down

Conventional wisdom these days is that in order for the Fed to bring inflation down, they are going to have to kneecap the economy. So with the Fed continuing to talk tough, it's no wonder that a majority expect to see a US recession some time this year.

Wrong. As I've been explaining for a long time, inflation has already dropped significantly, and the economy remains reasonably healthy. In fact, a healthy economy and a vigilant Fed are a tried-and-true prescription for low inflation.

The facts back me up:

Real GDP growth for Q4/22 came in slightly above expectations (2.9% vs. 2.6%), and inflation, according to the very broad GDP deflator, was also slightly above expectations (3.5% vs. 3.2%), although it was substantially less than the 9.1% rate of just six months ago. Looking back at last year as a whole, real GDP shrank at a 1.1% annualized rate in the first half of the year, and grew at a 3.1% annualized rate in the second half of the year. Inflation, according to the GDP deflator (the most inclusive index we have), was running about 8.7% in the first half of the year, and 3.9% in the second half. So inflation fell by more than half over the course of the second half of the year, even as real growth almost tripled! So much for "conventional wisdom."

Some charts to illustrate:

Chart #1

Chart #1 shows the quarterly annualized change in the GDP deflator, the broadest measure of inflation. Last year it peaked at 9.1% in the second quarter of last year, and fell to 3.5% in the fourth quarter. That's a huge decline that I would wager most people are unaware of.

Chart #2

Chart #2 is also one that I believe most people are unaware of. The blue line represents the size of the US economy in inflation-adjusted terms (aka real growth). It's plotted on a logarithmic axis which turns constant rates of growth into straight lines. The green trend line extrapolates where real GDP would be if the economy had continued its 3.1% trend growth rate that was in place from 1950 though 2007. The red trend line is the 2.2% annual growth trend that has been in place since the recovery started in 2009. What we see in recent years is a perfect example of Milton Friedman's "plucked string" theory of economic growth. It says that the economy tends to grow at a steady rate unless or until it meets a disturbance (e.g., a recession); and once that disturbance has passed, the economy "snaps back" to its former trend line. 

Voilá! The economy is growing at about 2.2% annual rate. Nothing special or surprising about that at all. But the real tragedy is that we could be growing at a much faster rate if our fiscal policy were sane instead of being dominated by burdensome regulations, green energy mandates, and egregious tax rates.

Chart #3

Chart #3 makes yet another appearance—it's one of my favorites. It shows that when the market gets very nervous (as measured by a rise in the Vix index), the stock market tends to swoon. And when confidence returns and the Vix index drops, stocks tend to rally. Confidence these days is slowly returning and the stock market is moving higher. 

Let's hope this continues; let's hope the Fed doesn't feel compelled to squeeze the economy just because inflation is a little higher than they would like to see. The truth is that on the margin, inflation pressures are receding (and by some measures inflation is already back down to 2%—see Chart #1 in this post) and the best way to keep inflation low is to allow the economy to continue to grow while keeping interest rates high enough to keep the demand for money from plunging. A greater supply of goods and services, after all, will help absorb any extra money that is still sloshing around. 

UPDATE (Jan 27): Today we learned that the growth rate of the Core Personal Consumption Deflator for December continued to fall. That's the Fed's preferred measure of inflation. As Chart #4 shows, the 6-mo. annualized rate of growth of this index is 3.7%. The total PCE deflator is up only 2.1% on a 6-mo. annualized basis. Inflation is rapidly ceasing to be a problem. 

Chart #4

Tuesday, January 24, 2023

M2 news continues to impress

For the past 18 months or so, I have argued that the surge in inflation which began about two years ago was fueled by a surge in the M2 money supply that began in the months following the Covid panic. The M2 surge, in turn, was created by the effective monetization of some $5 trillion of government checks (politely termed transfer payments) sent out to the citizenry, ostensibly to "stimulate" the economy.

As Milton Friedman might have described it, Congress printed up $5 trillion in new cash and hired a fleet of helicopters to drop it all over the country. He would have been surprised, however, that this didn't lead to an immediate surge of inflation. He theorized that people would rush to spend the cash they discovered in their backyards, thus giving inflation, and prices, a one-time boost. But I think he would understand that in this case, people simply stuffed the cash under their mattresses—they were under lockdown and couldn't spend it and, besides, there was so much uncertainty at the time that most people were content to just sit on their cash. For awhile at least. But by early 2021 Covid fears were easing and many people were anxious to get back to their normal lives. They started spending the money they had stashed away, and that was when inflation started to surge.

Today we received the M2 number for December '22, and it showed that the money supply has been shrinking at an unprecedented rate since its peak last March. People are spending down their excess cash balances and paying off loans, and that has been supporting a substantial rise in real GDP and a substantial rise in inflation as well. If the Fed has done anything right in this whole inflationary episode, it is to jack up short-term interest rates in unprecedented fashion (albeit too late); overnight rates have soared from 0.25% last March to now 4.5%. Higher interest rates worked to increase the demand for the excess cash, thus slowing the surge in spending and keeping inflation from exploding. Given the many signs that inflation is indeed cooling—commodity prices are down, real estate sales have ground to a halt, rents are falling, producer price inflation has plunged, oil prices are down by one-third—it looks like Fed rate hikes have substantially offset the inflationary potential of trillions of "excess" money supply.  

Chart #1

Chart #1 shows the growth in the M2 monetary aggregate. Since 1995, M2 had been growing on average by about 6% per year (green line), with occasional mini-bursts of growth which were later reversed. But the Covid helicopter drop saw by far the largest expansion in M2 in history. The peak in M2 occurred last March, at $21.7 trillion, which was $4.7 trillion above its trend growth. Since then M2 has shrunk, and it is now only $3.4 trillion above trend; "excess" money has thus dropped by almost 30%. Over the past six months, the annualized rate of growth of M2 has been -3.7%; over the past 3 months, M2 is down at an annualized rate of 5.4%. This is very good news.

Chart #2

Chart #2 is powerful evidence that the surge in M2 growth was fueled by a massive increase in the federal deficit, which was effectively monetized as people deposited their checks and held on to the funds. Although it's a shame the deficit has started to rise again, it's nice to see that this time it is not being monetized. If Congress fails to reform its spendthrift ways it will be a shame because excessive government spending just weakens the economy. But there is reason to believe it won't aggravate inflation.

Chart #3

Chart #3 suggests that there is a 12-16 month lag between the growth of M2 and the rise in inflation. It further suggests that the significant decline in M2 over the past 9 months means that consumer price inflation is likely to continue to fall for the balance of this year and possibly well into next year, thus meeting the Fed's objective.

Chart #4

Chart #4 shows the public's demand for money, which is proxied by dividing M2 by nominal GDP—think of it as the amount of the average person's annual income he or she prefers to hold in cash and cash equivalents. The inverse of this is commonly known as the velocity of money, which has been surging as money demand has been falling. The chart further suggests that we are likely to see further declines in money demand (and further increases in money velocity) before this is all over. Why couldn't money demand return to its pre-Covid levels? To keep this from happening too quickly (since that would boost inflation), the Fed will need to keep interest rates relatively high for at least the balance of this year. It's nice to know that this is what the bond market fully expects to see—which means we won't be in for any unpleasant shocks.