A Goldilocks economy?

When I review recent news and ponder the meaning of the charts below, these are the thoughts that come to mind:

The M2 money supply is well-behaved—the excesses of the Covid era have been absorbed—and it is once again growing at a rate that in the past has been consistent with relatively low inflation. Interest rates at current levels (5-yr Treasury yield ~4.5%, 10-yr ~4.7%) seem about right given a relatively slow-growing economy and inflation of 2-3%. Corporate profits are on the moon—literally off the charts. Stocks are fairly valued, maybe a bit rich, given the current level of interest rates. Unemployment is low and falling. Jobs growth is slow (1.5-2%) but increasing. The Fed is not making any big mistakes. Woke energy policies are fading fast, even in Europe, and AI is spreading like wildfire. Global economies are thus likely to enjoy a tailwind for the foreseeable future. Is this a Goldilocks economy, or what?

Chart #1

Chart #1 compares the level of 5-yr Treasury yields to the ex-energy rate of inflation. (Energy is by far the largest contributor to the ups and downs of inflation, and the war in Iran has only made matters worse.) Interest rates at current levels have kept inflation in check in the past, and now seem likely to exert a bit of down pressure on inflation going forward. Regardless, I continue to believe that the inflation statistics overweight and over-measure shelter costs, and that problem is slowly receding.  

Chart #2

Chart #2 shows the level of the M2 money supply plotted on a logarithmic scale to highlight its fairly constant growth rate over time. M2 grew by about 6% a year from 1995 through 2007, and during that time inflation was relatively low and stable. Today, M2 is only slightly above its long-term trend. 

Chart #3

Very few analysts track the relationship of M2 to nominal GDP. I think it is a good measure of the demand for money, and that is key to being able to understand whether the Fed is doing its job with the money supply. (Inflation happens when the supply of money exceeds the demand for it.) Money demand is back to where it was prior to the Covid era. Coupled with the 6% growth rate of the M2 money supply, this leads me to the conclusion that monetary policy likely is in a sweet spot for now. (Long-time readers will know I have been saying this for the past several years.)

Chart #4

Chart #4 shows the ratio of economy-wide corporate profits (a key component of the GDP accounts) to nominal GDP. Think of this as a proxy for corporate profit margins. Corporate profits are at historically high levels, and more than twice what they were in the 1970s and 1980s, as the dashed green lines show. No economist in his right mind would ever have predicted this, and I certainly didn't. With corporate profits at record levels and growing, is it any wonder that the stock market is making new highs?

Chart #5

Chart #5 shows the level of the S&P 500 index plotted on a logarithmic scale. The green line is a stand-in for the long-term growth trend of this index (~8% per year). Pay particular attention to the 2008-2009 recession, and how this resulted in a severely depressed stock market. Now note that the S&P 500 has come back to its long-term growth trend; this is why stocks have had such a strong run over the past 17 years.

Chart #6

The red line in Chart #6 compares the actual market capitalization of the U.S. stock market using the S&P 500 index as a proxy, while the blue line is the result of capitalizing the measure of corporate profits that I have used in preceding charts. To capitalize profits I divide corporate profits by the 10-yr Treasury yield)*. Note that the market cap was significantly lower than capitalized profits from 2009 through 2024; this corresponds to an underperformance relative to trend from 2009 through 2024 that shows up in Chart #5. It is certainly likely that the undervaluation of stocks during that period was exaggerated by the fact that the Fed was mistakenly keeping interest rates historically low for a number of years.

None of this is science, to be sure, but from two different perspectives it seems that as of a few years ago, stocks have returned to prior trends and are now more or less fairly valued. This could of course change if the Fed were to significantly raise interest rates, since that would reduce capitalized profits and in turn depress stock prices.

* Reasonable people could argue about which yield to use when capitalizing profits, but I think the 10-yr Treasury yield is as good as any. I credit Art Laffer with bringing this method of equity valuation to my attention many years ago: he used it in early 2000 to correctly argue that stocks were overvalued and due for a fall.

Key facts about federal debt you might have missed.

Our national debt is once again in the news, since it has supposedly reached a staggering $40 trillion. I say "supposedly" only because that's not really true. $40 trillion is the amount of Public Debt Outstanding, which includes $7.75 trillion of Intergovernmental Holdings (which means the debt that one branch of the government owes to another). The true measure of federal debt is Debt Held by the Public, which is now $32.3 trillion. You can see the history of all these numbers here. 

I offer the following charts—some of which you've likely never seen before—to help one understand our national debt and its implications.

Chart #1

Chart #1 shows a long history of federal debt owed to the public. It's plotted on a logarithmic scale so you can appreciate how fast or slow it's been growing over time. Over the period shown, federal debt has increased by an annualized rate of 8.8% per year. Note that the growth of federal debt in recent years is not very different from what it's been over the past seven decades on average. 

Chart #2

Chart #2 shows the evolution of federal spending and federal revenues since 1990. It's also plotted on a logarithmic scale. The difference between the two lines is the federal deficit, which in the past 12 months has totaled $1.95 trillion. Note that spending has slowed dramatically since 2022, while revenues have been grown significantly in the past few years.

Chart #3

Chart #3 shows federal spending and federal revenues as a percentage of GDP. The dashed lines show post-War averages for both. Federal revenues relative to GDP today are only slightly lower than they have been for many decades, but federal spending is substantially higher. From this fact alone it's not a stretch to say that the main reason we have a large federal deficit is that federal government is spending very high from an historical perspective.

Chart #4

Chart #4 shows federal revenues as a percentage of GDP vs. top federal income tax rates. Remember the hue and cry when President Reagan slashed tax rates in the 1980s? Supply-siders like Art Laffer argued that lower tax rates would be such a stimulus to growth that revenues would remain strong. Left-wingers argued that the deficit would explode. Based on this chart it's easy to say that if anything, lower tax rates led to a surge in tax revenues from 1983 through 2000. It's the Laffer Curve in action; if tax rates are too high, then lowering them will lead to more growth, rising real incomes, and higher tax revenues. Tax rates were clearly too high in the decades leading up to the 1980s.

Extrapolating from Charts #3 and #4, the worst thing the federal government could do to reduce the deficit is to raise tax rates. Lower spending is the only sensible course of action.

Chart #5

When people speak about the burden of the federal debt, they usually refer to the size of the debt relative to the size of the economy. That's shown in Chart #5. Today federal debt is a smidgen less than the size of our economy. It's only been higher during WW II. But that's not a good measure of our debt burden.

Chart #6

Chart #6 shows federal debt as a percentage of GDP, which is the correct way to measure the burden of our debt. Note that it was much higher in the 1980s than it is today. That's because interest rates were much higher back then than they are today. Example: having a mortgage that is equal to 30% of your annual income is much harder if mortgage rates are 8% than if they are 6%. Chart #7 gives you the history of 10-yr Treasury yields to help keep these facts in perspective.

Chart #7

Is our federal debt out of control? a ticking time bomb? No. It's still manageable, but we would all be much better off if the federal government downsized its spending and reduced our tax and regulatory burdens. 

Jobs growth picking up a bit

The June payroll data released a few days ago bolsters the thesis that jobs growth is picking up. Jobs growth is still modest by historical standards, but it is improving, not deteriorating, and that is significant. 

Chart #1

Chart #1 shows the year over year and 6-mo. annualized rate of growth of private sector jobs. Given the volatile nature of month-to-month rates of change of this statistic, I think it is best to view it from a multi-month rate of change perspective. We now see that by both measures, jobs growth is picking up a bit. But at best, the current rate of growth is still less than 1% per year. 

Chart #2

Chart #2 shows the level of private sector and public sector jobs. Here we see that private sector jobs have picked up a bit, whereas public sector jobs have lost ground in the past year or so, thanks to Trump's efforts to downsize the federal bureaucracy. 

I don't see anything here that would justify or warrant a change in short-term interest rates. The economy is not on the verge of a sudden acceleration, nor is it on the verge of a downturn. 

Meanwhile, key indicators of inflation pressures bolster the case for lower inflation: non-energy commodity prices are down 4.5% from their pre-Iran levels, 5-yr breakeven inflation rates have fallen to 2.3% from an Iran-war high of 2.75%, and gold prices are down 10% and the dollar is up 3.5% since the end of February.