Slow M2 growth fuels stronger economic growth with low inflation

Yesterday's release of the December M2 money supply figures showed a continuation of the sub-6% growth trend that has been in place since inflation peaked in mid-2022. Despite over three years of very sluggish money growth, economic growth has exceeded most expectations. Why? Because money that was stockpiled during the Covid winter has been steadily released to fuel increased economic activity, while at the same time inflation has remained relatively low and federal deficits are shrinking.

The monetary and inflation fundamentals are pretty darn good these days, with the possible exception of the dollar, which has weakened on the margin in recent months. I am not worried about that, however, because the dollar remains substantially stronger than its long-term average in trade-weighted and inflation-adjusted terms. I'm not worried either about the surge in gold prices, which have recently surpassed $5,300/oz and appear to exist in an alternate universe. Abstracting from gold, commodity prices are well-behaved and show no sign whatsoever of inflationary behavior.

The following charts expand on these observations:

Chart #1

Chart #1 shows the level of the M2 money supply, plotted using a logarithmic y-axis to better illustrate how money grew at roughly a 6% annual rate from 1995 through 2019—a period during which inflation was well-behaved, averaging about 2% per year. M2 growth exploded beginning in 2020, as the federal government began "printing" some $6 trillion to fund massive transfer payments. The Fed finally woke up to this problem and began to hike interest rates in 2022, and money-printing ceased. Result: M2 is largely back to where it would have been had the Covid fiasco never happened.

Chart #2

Chart #2 is constructed to illustrate how inflation has tended to lag changes in money supply growth by about one year. The initial surge in money growth was not immediately inflationary because huge Covid-related uncertainty caused economic actors to stockpile money. In other words, Covid led to a huge increase in money demand—which meant that a huge increase in money supply was neutralized by a correspondingly huge increase in money demand. But after a year or so, money demand subsided and the money that had been stockpiled began to be spent, and that fueled rising inflation. Today we're essentially back to "normal," thanks to higher interest rates and saner fiscal policies. 

Chart #3

Chart #3 shows the 6-mo. annualized rate of change of the M2 money supply. Money growth has been very slow ever since inflation peaked in mid-2022, and although it has picked up in the past few years, it is still below the 6% trend that prevailed in the 1995-2019 period. The Fed made a huge inflationary mistake in the 2020-2022 period, but they now have the situation back under control. A flareup in inflation against a backdrop of 4-5% M2 growth, positive real interest rates (the 5-yr TIPS yield today is 1.3%), and declining federal deficits is therefore highly unlikely. Great news!

Chart #4

Chart #4 illustrates what I have called "money demand." It is the ratio of M2 to nominal GDP, and it can be thought of as a proxy for the amount of spendable money the average person or business wishes to hold relative to their annual income. Today money demand stands at just over 70%, having fallen from a peak of just over 90% in 2020. It is almost back to pre-Covid levels. Today there's no excess supply of money, and the demand for money has returned to levels that are much more normal. Result: low inflation for the foreseeable future. 

Chart #5

Chart #5 shows rolling 12-month totals for federal government spending and revenues. After exploding higher in 2020, federal spending has largely stabilized in recent years. Spending peaked at $7.62 trillion in March 2021, and last year spending totaled $7.05 trillion—that's almost five years of no spending growth! Over the same period, revenues surged from $3.52 trillion to now $5.38 trillion. As a result, the federal deficit has fallen from a high of $4.1 trillion in March 2021 to now only $1.7 trillion. That's still way too much, but it is almost certainly going to decline further. We're slowly getting back to normal. 

Chart #6

Over the past year, the dollar has fallen by roughly 10%. Normally that would be a cause for concern, especially since I believe that a strong currency is always better than a weak one. But as Chart #6 shows, when you adjust for inflation, the dollar is still trading about 15 to 18% above its long-term average. In a way, the dollar has gone from being very strong to just strong. I was relieved to hear Treasury Secretary Bessent today reiterate that a strong dollar is in our nation's best interest. 

Chart #7

Chart #7 shows the 75-year history of the S&P 500 index, which has grown by about 8% per year. It's a bit on the strong side of that trend, but nothing here looks particularly worrisome. Investors see a stronger economy, and they are voting with their feet. Makes sense.

Chart #8

Chart #9

Charts #8 and #9 are constructed in similar fashion. The blue line is the inverse of a popular dollar index (i.e., upward moves signify weakness, and downward moves strength in the dollar), while the red line in the first chart shows the inflation-adjusted price of gold, and in the second chart, the red line shows an inflation-adjusted index of a basket of 22 basic commodities. Note that in Chart #9, inflation-adjusted commodity prices have a strong tendency to move inversely to the changes in the dollar's value. (The nominal (non-inflation-adjusted) version of that same index has been flat for the past 4-5 years even as the dollar has weakened.) 

Gold and silver today are the only major commodity prices (with the notable exclusion of copper, which is facing heavy demand from AI-related industries) that are going up—and dramatically so. One important conclusion: gold and silver are fundamentally different from things like soybeans and sugar. Their rising prices do not necessarily imply a weaker dollar or higher inflation.

From this it follows that gold and silver should not be lumped together with other commodities. They just don't behave in the same manner. In any event, I wish I knew the cause and the implication for inflation of soaring gold prices, but I don't. It could just be rampant speculation, and/or heavy buying on the part of central banks trying to diversify their exposure to fiat currencies. In the latter case, I would be quick to add that central banks have a poor record when it comes to predicting inflation.

A return to relative tranquility

This is a short note to highlight the significant decline in market volatility over the course of the past year.

Price volatility is often thought of as "fear" that stems from uncertainty. The Vix Index, technically defined as the implied volatility of equity options, is the most common measure of volatility in the stock market, while the MOVE Index uses the implied volatility of Treasury bond options. The expected and implied volatility of prices underlying each index is a key determinant of the price of related options contracts. Higher expected volatility drives the price of options higher, and vice versa. Since purchasing options contracts reduces and investor's risk, options are highly prized (and thus more expensive) during periods of market distress. During periods of relative calm, investors are less likely to purchase options, and thus their prices decline. 

Chart #1

Chart #1 compares the Vix Index (white line) to the MOVE Index (orange line). Not surprisingly, both tend to move in tandem, but not always to the same degree. The last significant increase in volatility occurred last Spring, when Trump shocked the world with huge tariffs on U.S. imports. As the chart shows, volatility has subsided meaningfully since the Spring peak, and it now approaches levels which in the past have been associated with relatively calm (and often optimistic) equity and bond markets. 

The current relatively low level of both volatility indices is in many ways equivalent to a market-based measure of investors' confidence or sentiment. The market has lost its fear of tariffs, as many have been reduced or eliminated, and those remaining have failed to move the needle on inflation (as any economist worth his salt would have predicted) and do not appear to have posed much of an obstacle to growth (though I think the economy would be stronger without them). The principal value of Trump's tariffs derives from his ability to use them to achieve certain worthwhile objectives (e.g., reciprocal reductions in tariffs with some of our trading partners).

Improved confidence in the future is a good thing in and of itself, since it surely promotes greater saving and investment, which ultimately translate into more and better-paying jobs and higher living standards. On the other hand, finding good values in a period of tranquility becomes harder, and the market becomes more susceptible to disappointments. There's no free lunch, but things could certainly be a lot worse than they are today.

Lots of things are looking up

Valued readers, please excuse me. For the past few months I've suffered from writer's block complicated by a lack of government-produced data. I now have some facts to work with, and they look pretty good. I've assembled a baker's dozen of my favorite charts here, and I will try to keep the commentary lean and let the charts do the heavy lifting. It feels a lot like Christmas!

To sum up: The economy is in decent shape (2-3% growth) and inflation remains subdued (2.5% or less). More specifically, the M2 money supply is growing at a very moderate 4.5% rate and most if not all of the $6 trillion increase in M2 that was "printed" during the Covid era has been absorbed. There is still no evidence that Trump's tariffs have boosted inflation. The main source of slightly-above-target inflation in recent years can be traced to the government's faulty measurement of housing and shelter costs, and these have finally subsided and should remain low (if not negative) for the foreseeable future. 

Commodity prices (abstracting from gold, which appears to inhabit an alternative universe) are very well behaved, and haven't shown any meaningful increase for years. GDP growth was surprisingly strong in Q3/25, and Trump's Big Beautiful tax cuts, coupled with impressive deregulation and an actual shrinkage of the public sector workforce, have set the stage for continuing growth in the coming year. It is comforting to see a 4-5% increase in business investment so far this year (e.g., capital goods orders and shipments), and it is now common knowledge that AI is already contributing to improved productivity. Finally, it is also VERY comforting to see that federal government spending has not increased at all over the past 12 months, while revenues have surged by almost 10%! 

Chart #1

Chart #1 shows the level of the M2 money supply, arguably the best measure of readily-spendable money. It grew at a 6% pace from 1995 through 2007, during which time inflation averaged about 2%. Then all hell broke lose: M2 surged by some $6 trillion in a 2-yr period, fueled by Covid stimulus spending which was effectively monetized. That bulge now has all but disappeared.

Chart #2

Chart #2 shows the 6-mo. annualized growth rate of M2, now a mere 4.6%. The economy is now on a low-inflation monetary diet. As I have said about M2 many times in the past 5 years, this is arguably the biggest news that no one, not even the Fed, is paying attention to. 

Chart #3

Chart #3 shows the ratio of M2 to nominal GDP. I call this the "demand for money," since it essentially measures how much of our annual incomes we prefer to hold in the form of money. Money demand surged in the first year or so of Covid, because people were terrified and largely unable or unwilling to spend all the cash the government was doling out. Strong money demand effectively neutralized the surge in the M2 money supply, which explains why inflation didn't start rising for a year after M2 began to soar. Money demand then collapsed beginning in mid-2022, as things began to return to normal, and that effectively offset the collapse and actual shrinkage of M2—that's why a contracting money supply didn't cause the recession that was so widely anticipated. (Remember: inflation happens only when the supply of money exceeds the demand to hold it.) Now money demand is almost all the way back to where it was prior to Covid.

Chart #4

Chart #5

Chart #4 compares the strength or weakness of the dollar to the level of inflation-adjusted spot commodity prices, while Chart #5 shows the nominal level of those same commodities since early 2020. These are all very basic commodities, not the sort that are subject to speculative pressures (like gold can be). What we see here is a very strong inverse correlation between the dollar and real commodity prices. A stronger dollar tends to coincide with weaker commodity prices, and vice versa. Note that commodity prices over the past 33 years haven't changed at all in real terms, and the dollar has only strengthened modestly. Over the past several years, commodity prices have gone nowhere—a strong symptom of an absence of underlying inflationary pressures.   

Chart #6

Chart #6 is structured the same way as Chart #4, except that I've used the inflation-adjusted price of crude oil. In real terms, oil prices are relatively low, and that reinforces the outlook for low and stable inflation. Oil is the most volatile of all commodity prices, and the price of energy is an important contributor to the economy's health. Nationwide gasoline prices are currently just under $3 per gallon, and that is roughly what gasoline prices have averaged over the past 20 years. This is very good news for economic growth.

Chart #7

Chart #7 looks at the short-term, annualized rate of change in Owner's Equivalent Rent, which in turn constitutes about one-third of the CPI. In the past two months, this important component of the CPI has decelerated markedly; this will subtract meaningfully from reported inflation over the next 10 months.

Chart #8

Chart #8 compares the year over year change in the total CPI to its ex-shelter version. The gap between the red and blue lines over the past 2 years is largely due to the government over-estimating shelter costs. The gap has now all but closed. 

Chart #9

Chart #9 shows the long-term growth trend of real GDP (green line), which averaged about 3.1% per from the post-war period through 2007. Sadly, the economy has yet to return to those glory days; growth has averaged only a bit more than 2.3% per year since the Great Recession ended in 2009. Why this huge shortfall? I suspect a variety of culprits: massive increases in transfer payments (e.g., green energy subsidies, Obamacare), burdensome regulations (e.g., CAFE standards), and DEI hiring, to name a few. Stepping back, mankind has spent several trillions of dollars on inefficient energy projects in a vain attempt to "save" the planet from climate change. A return to efficient energy investment appears already to be underway. This is great news for the planet and its economies.

Chart #10

Chart #10 tracks the growth of private sector jobs in recent years, which are now growing at a snail's pace. Contrast this to the surprisingly strong growth of Q3/25 GDP (4.3%) and you must conclude that productivity is on the rise by more than enough to offset the drag of massive deportations of illegals. Meanwhile, federal government payrolls have shrunk by 9% (273K) so far this year! To my mind that's the equivalent of pouring much less sand into the wheels of commerce. 

Chart #11

Chart #11 shows the inflation-adjusted price of gold over the past 113 years. Monetarists like me have trouble reconciling soaring gold prices with an apparent absence of inflation pressures. Central banks have meaningfully increased their purchases of gold in the past four years, and that at least partially explains gold's rise to levels never before seen—or even imagined. On the other hand, this could be a classic case of speculative froth which eventually exhausts itself and collapses. The 30% collapse in Bitcoin prices since early October could be a harbinger of trouble ahead for other markets. 

Chart #12

Chart #12 paints a disturbing picture, suggesting that the recent collapse in bitcoin could be presaging a similar decline in equity prices. The market cap of crypto currencies peaked at $4.28 trillion on October 6th, and current stands at $2.95 trillion; $1.33 trillion of paper wealth has thus evaporated in a matter of weeks. Dabble in gold and bitcoin at your peril. I wouldn't touch the stuff—give me real, productive assets instead.  

Chart #13

Chart #13, in contrast, paints a hopeful picture; federal government finances look to be returning to some measure of sanity. Federal government spending has been flat for the past year, while revenues have increased by 10%. The days of $2 trillion dollar annual deficits are fading fast. Federal debt owed to the public has been 90-100% of GDP for over 5 years (it peaked at 103% in mid-2020) and may soon begin to decline. In the meantime, the true burden of our national debt is currently 3.7% of GDP, and that is significantly less than the 4.5-5% levels which prevailed during the 1980s. There is still reason to be optimistic.

Happy New Year!

P.S. Thanks to Larry K for the words of encouragement!