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. 

Corporate profits are very healthy

Corporate profits are the mother's milk for equity prices, and they are stronger than ever relative to the size of the economy. No wonder the stock market has done so well in recent decades.

Chart #1

Chart #1 compares corporate profits (adjusted, and ex-Fed profits) to nominal GDP. According to the Q4/25 GDP estimates released today, corporate profits at the end of last year were up 8.4% from a year ago, and they totaled $3.6 trillion at an annualized pace.

Chart #2

Chart #2 shows the ratio of corporate profits to nominal GDP. As of the end of last year, profits were a record-setting 11.5% of GDP. Wow. Just Wow. And it's not just a recent phenomenon. As the chart also shows, relative to the size of the economy, profits in recent years have been running twice as strong as they were in the 80s and early 90s.

Chart #3

Chart #3 shows the long-term path of the S&P 500 index, as compared to an 8% annualized trend. When you add dividend yields of 1-2% per year, buying and holding stock in the country's 500 largest and most successful corporations has yielded about 10% per year since 1950.

Of course, there are times when returns have been far less than 10% per year, and far greater. If you bought stocks in October 2000, you wouldn't have broken even for almost 7 years. In contrast, buying stocks in April 2009 (at the bottom of the Great Financial Crisis) would have delivered annualized returns of almost 15% plus dividends. I was several months early when in November 2008 I argued that investing in stocks was the buying opportunity of a lifetime.

In any event, these three charts suggest that stocks today are neither very cheap nor very expensive from an historical perspective. 

The market is not very nervous

As I write this, we are only 3 hours away from Trump's ultimatum to Iran: open the Strait or face annihilation. Personally, I can't see the current Iranian government being willing to capitulate. By the same token, I can't see Trump carrying out such a threat. 

Perhaps that is what the market is thinking as well, because there is little in the way of market pricing that suggests investors are very concerned about the consequences of today's upcoming events.

Chart #1

Chart #1 shows the 10-yr history of the Vix index, commonly known as the "fear" index. Technically, it's the implied volatility of equity options. A higher value corresponds to greater fear and also to more expensive option prices. When you're nervous it's sometimes smart to buy options since they can minimize your risk. The more nervous you are, the more you're willing to pay. Today's Vix index is elevated, but hardly to an extreme level such as we have seen in prior episodes of fear. 

Chart #2

Chart #2 shows the level of corporate credit spreads. The higher the spread, the more the market is concerned about the outlook for corporate profits. Spreads have ticked higher in recent weeks, but not by very much. If all you knew was the level of credit spreads, you would see this chart and conclude that the market is not concerned at all about the economic outlook. 

Chart #3

Chart #3 is another way of looking at corporate credit spreads: it's the difference between investment grade and high-yield spreads. This too shows very little concern.

Chart #4

Chart #4 shows the yields on 5-yr Treasury bonds (i.e., nominal yields) and 5-yr TIPS (i.e., real yields), plus (in green) the difference between the two, which is effectively the market's expectation for what the CPI will average over the next 5 years. It's tough to see anything here that is out of the ordinary.

I hope the market is right, and I hope the problems in the Gulf are nearing a peaceful resolution.