Tuesday, February 22, 2022

M2 growth continues at a rapid pace

Today the Fed released the M2 money supply numbers for January 2022, and unfortunately, they show continued double-digit growth. This means the Fed still has its monetary pedal to metal, and that all but confirms that we are in the midst of a genuine and ongoing period of high inflation. The Fed has made a major inflationary mistake, and it's going to take a long time to fix. If I had to guess, we will be seeing inflation rates of 10% or so through at least the end of this year. 

But as the Fed continues to tell us, they plan to move very slowly to raise rates. The bond market—still a believer in the Fed's ability to keep things under control—is projecting that the Fed will need to raise the Fed funds rate to only 2% or so within the next year or so, and that will fix the problem. That projection is almost certainly going to be very wrong. As a first approximation, the Fed needs to raise short-term rates to a level that is at least equal to the rate of inflation. See my last post for a more detailed explanation.

Chart #1

Chart #1 is the most important yet largely ignored chart in the financial world today. I've subtracted currency in circulation (which comprises about 10% of M2) because, as I explained earlier, currency is held only to the extent it is demanded, thus it is not a source of inflation. The rest of M2 (checking accounts, savings accounts, CDs, retail money market funds) is money that is held for the public (not institutional accounts) in our banking system. That is money that is created by the banks themselves, provided they hold sufficient bank reserves at the Fed. And as we know, bank reserves (currently about $4 trillion) far exceed what the Fed requires that banks hold. Which in turn means that banks have a virtually unlimited capacity for extending loans and thus expanding the money supply. And by the looks of the chart, they have been printing money with relative abandon for most of the past two years.

Since the pre-Covid days (February '20), the non-currency portion of M2 has increased by about $6 trillion, or 43%. Since early-summer '20, that same measure of the money supply has increased at about a 13-14% annual rate, a bit more than twice it's long-term average growth rate. Needless to say, this is all unprecedented. And very worrisome.

Recall Milton Friedman's famous dictum: "Inflation is always and everywhere a monetary phenomenon, in the sense that it cannot occur without a more rapid increase in the quantity of money than in output." To know why we have unusually high inflation today, you only have to look at this chart. Supply-chain problems undoubtedly had a roll to play (a spark, if you will), but the fuel for the broad-based rise in the general price level that we see today unquestionably has been supplied by an historic expansion of the money supply.

Chart #2

I have included Chart #2, which shows the total M2 money supply, because I want to dispel fears that I was massaging the numbers in Chart #1. Both charts show that over long periods the broadest measure of our money supply has tended to grow at about a 6% annualized rate. And we are soaring above that as I write. 

Milton Friedman also talked about a "helicopter drop" of money on the economy, and how a sudden and massive increase in the amount of money in the economy would almost certainly result in an increase in the general price level. Well, it's effectively happened, and we can observe the results. 

We should all be monetarists now. 

Sunday, February 20, 2022

The Fed is not addressing perverse incentives

Faced with much-higher-than-expected inflation, the Fed is nevertheless taking great pains to assure markets that they will address the problem in a slow and gradual fashion, by taking 25 bps baby steps per month to raise the federal funds rate beginning next month. They seem to be aligning with a school of thought that says the economy these days is too weak to sustain a rapid increase in interest rates, so it's better to be slow and gradual than shock and awe.

While this reinforces the point of my last post (i.e., the Fed poses no near-term threat to the economy), it will likely only make things worse in the long run. Why? Because by pre-announcing a gradualist approach they have given investors and the public a green light to take advantage of incredibly cheap financing costs, and that will only make inflation harder to control in the future. Why harder to control? Because increasing the incentive to borrow money to buy things (cars, houses, commodities, property, plant and equipment) is equivalent to decreasing the incentive to hold money.  Borrowing money means going short money: you win if the value of the dollar declines. Paying off debt means going long money: you win if the value of the dollar increases. With the supply of money (e.g., M2) obviously in over-supply, the Fed is incredibly trying to undermine the demand for holding that money. They couldn't be more wrong.

From a monetary perspective, the U.S. faces a gigantic, two-sided problem: a huge surplus of money and a lack of demand for all that money. That adds up to a turbo-charged inflation environment wherein money becomes a hot potato that no one wants to hold because it is losing value. To better understand that process, once again I recommend my post from last summer: "Argentina inflation lessons for the U.S.

What follows are some charts that help illustrate what is going on.

Chart #1

Chart #1 shows the real and nominal value of used cars, as calculated by the folks at Manheim Consulting (and using the CPI to determine inflation-adjusted prices). Prices in nominal terms have nearly doubled in the past two years! Sure, a lot of this is due to supply chain problems—with no chips they can't build and sell new cars, so with demand pumped up with lots of transfer payments, car prices have nowhere to go but up. That's the argument for the current inflation spike to be transient. But that ignores the fact that a whole lot of prices are up and people are paying those prices and still want more. Those who are flush with cash can pay those higher prices, but that doesn't reduce the cash available to spend, since the cash that buyer A hands over then sits in the account of seller B. More rapid spending doesn't deplete the stock of excess cash, it simply spreads it around. Without excess cash there could not be a general increase in prices.

Chart #2

Chart #2 is one of the most important yet largely ignored chart in the world today, in my view. It's a graphic depiction of just how much extra money is sitting in the bank accounts of the U.S. public (M2 excludes corporate cash, by the way). Relative to what we would have expected M2 to be today, there is an extra $4.3 trillion dollars that has landed in bank accounts in the past two years. At first, with Covid lockdowns and general panic reigning, the public was happy to have all that money socked away, but now that life is getting back to normal, people are trying to spend it. And it shows—just look at the soaring prices of homes, cars, commodities, food, etc.

There are two ways the Fed can fix this problem, but those solutions are not yet even on the table. For one, they can reduce banks' ability to increase their lending by dramatically shrinking the Fed's balance sheet (i.e., the Fed needs to sell trillions of bonds in order to soak up trillions of excess reserves held by the nation's banks—a process otherwise known as Quantitative Tightening). Alternatively, and additionally, they can raise the interest rate they pay banks that hold those extra reserves, thus making lending to the private sector less appealing than lending to the Fed (lending to the Fed by holding bank reserves is a no-risk proposition, unlike lending to the public). And of course they can and most probably will do both—eventually. But to do it right they need to act swiftly and decisively. If they don't, troublesome inflation is going to be with us for years.

Chart #3

Chart #3 shows the history of rates on 30-yr fixed rate mortgages. Just a few months ago they were trading at all-time lows—less than 3%! Just think of all the happy people who refinanced their mortgage in recent years and then discovered that housing prices have risen over 20% in just the past year. Do the math: if you got a 3% mortgage with a 20% down payment ($100,000) to buy a $500,000 house a year ago, you have paid only $15,000 in interest and your house has gone up by 20% ($100,000). That equals a total return on your down payment of 85% ($85,000)! There's a handy shortcut to figure out how much profit you can make by borrowing money to buy property: If the required down payment is 20%, then you are taking on 5 times leverage (100/20). Multiply the amount of leverage by the difference between the asset's annual appreciation and your annual interest cost (in this case, 5*(20% - 3%) = 85%, and you get your profit. 

I'll bet lots of people today are looking at borrowing costs and comparing that to their expected returns. If you bought a car a year ago with a 3% loan and 10% down, you could realize an obscene profit by selling the car today. Say you sell it for only 25% more than its initial selling price (I'm being really conservative here). That would give you a profit of 10*(25% - 3%) = 220%!

With interest rates so low relative to inflation, it's no wonder the money supply is surging: when banks make loans, they create money out of thin air by crediting the borrower's account. Rising inflation expectations encourage borrowing, and more borrowing expands the supply of money. 

So, is the recent 1-point jump in mortgage rates likely to crush the housing market? I seriously doubt it, as long as home prices rise by more than the current mortgage rate, which is about 4%. 

Chart #4

Chart #5

Chart #6

Chart #4 shows the level of single family home sales, which has been rising for the past decade. Over that same period, national home prices have increased by an annualized rate of just over 7%, according to the Case Shiller data, and 30-yr fixed rate mortgage rates have averaged about 3.8%. Someone lucky/smart enough to buy a home a decade ago with 10% down has made a profit of 32%.

Charts #5 and #6 are the natural result of these factors: people are buying homes faster than they come on the market. Nationwide, the supply of unsold homes has never been so low relative to the pace of sales. And of course that only keeps upward pressure on home prices. One caveat: Chart #6 suggests that real home prices tend to rise, on average, by about 1.1% per year. Current prices are running hot (over trend), so they might not have a lot further to go. I would expect them to cool off; in real terms, that means they continue to rise by something less than prevailing rate of inflation. The Fed needs to jack rates higher—much higher to avoid this.

Moral of the story: when interest rates are low relative to inflation, people are incentivized to borrow and buy. Which is what I've been recommending for many years, by the way. And that in turn fuels inflation by expanding the money supply. Unless, of course, the Fed takes steps to unwind the perverse incentives that are in place today. 

Chart #7

Now back to the bond market and what it is thinking about inflation. That's summarized in Chart #7, which show 5-yr real and nominal Treasury yields and their difference, which is what the market expects that consumer price inflation will average over the next 5 years. Inflation expectations have now reached their highest point since the introduction of TIPS in 1997: 2.9%. (Prior to that we had no way of directly measuring inflation expectations.) But expectations are still far short of where actual inflation is, which means the bond market is pretty confident that the Fed will get things right before too long. But I'm not so sure.

Chart #8

Chart #8 compares the real yield on 5-yr TIPS to the current real yield on Fed funds. The former is best described as the value that the market expects the latter to average over the next 5 years. Apparently, the bond market expects the Fed to raise the real yield on overnight assets significantly over the next 5 years from its current abysmally low level of almost -5% at the same time that inflation falls significantly. Regardless, the market doesn't expect real yields to be positive until many years in the future, which implies the market is quite pessimistic about the long-term health of the economy. So: the bond market thinks the economy will be quite weak for the foreseeable future, and inflation will soon return to levels that the Fed is targeting (2-3%). Those are courageous assumptions, I would argue.

Chart #9

Meanwhile, we can't lose sight of the fact that interest rates are currently WAY below the level of inflation. As explained above, this by itself creates incentives which work to push inflation higher. It's useful to compare today to the 1970s to fully appreciate the Fed's predicament today. Back then, inflation surprised to the upside and it took the Fed more than 10 years to get it back under control. The Fed broke the back of inflation only after it raised rates (by curtailing growth of the M2 money supply and jacking up the Fed funds rate) to a level which exceeded the rate of inflation. They may well have to do that again. Unfortunately, almost no one expects that to happen. So the next several years could be a bumpy ride, but the bumps won't start coming for awhile.

Note also that once inflation started to decline in the early 1980s, the bond market was very slow to react. Real interest rates (the difference between the blue and red lines) were very high initially and then gradually subsided. Today real interest rates are decidedly negative, much as they were during a portion of the 1970s (see Chart #10). Negative real rates tend to occur during times when inflation exceeds expectations and the Fed is slow to respond—that is what happened in the late 1970s, and the past looks set to repeat.

Chart #10

I will be watching breathlessly for the monthly M2 numbers to be released around the end of the third week of each month. I will only breathe easy if they start showing a declining rate of growth, which is currently around 12-13% on an annual basis. I will be pleased if the Fed becomes more concerned about inflation and starts raising the Fed funds rate more aggressively at the same time they start selling the bonds they hold (to reduce bank reserves) more aggressively. The Fed desperately needs to address the perverse incentives they have created.

Although the market might well react negatively to an aggressively tightening Fed, I would see it as a reason to be optimistic. How could it be bad for the Fed to do what they should be doing?

Wednesday, February 9, 2022

Fed tightening is not a near-term threat

It's no secret that an aggressive tightening of monetary policy can be a real threat to the health of the economy. But even if the Fed surprises us with a 50 bps hike in short-term rates next month and even 4-5 more hikes by year end, policy will still be extremely accommodative. It's going to take a long time for Fed policy to become "tight," much less too tight. If this proves to be the case, then by inference inflation is very likely to be higher than the market expects, and for longer.

As I've noted in recent posts, there is one huge thing that is missing in all the buzz about inflation: the surging M2 money supply. And in virtually all the discussions about inflation, nearly everyone fails to mention that a widespread increase in many prices can only happen when there is a clear increase in the supply of money. If the Fed is doing its job, the supply of money should equal the demand for money. But if the Fed allows the supply of money to exceed the demand for money, then that's equivalent to boosting everyone's spending power: extra money is needed to drive a general increase in the supply of money. Without extra money in people's pockets, higher prices for energy (for example) mean that consumers have less money to spend on other things. But when energy, commodity, auto, home, and food prices rise significantly, that is virtual proof that there is an excess of money in the system. Which can only be remedied by the Fed adopting policies that increase the demand for money and reduce the supply of money.

What follows are some handy charts to use for reference as Fed policy progresses. 

Chart #1

Chart #1 is the best way to see whether monetary policy is tight or not. Notice the patterns that have repeated over the decades (with the exception of the sudden plunge in GDP two years ago): prior to every recession, the real Fed funds rate has surged to at least 3-4% and the slope of the yield curve has gone flat to negative. Those are classic hallmarks of tight money. Why? Because the Fed needs to raise real short-term rates to a level that discourages borrowing and encourages saving (i.e., to a level that boosts the demand for money). As real rates move higher, the demand for money becomes intense, liquidity becomes scarce, and marginal firms get squeezed. The bond market realizes that economic weakness is spreading and begins to anticipate a reduction in the real Fed funds rate in the future—so long term rates fall to or below the level of short-term rates. Currently, those two variables are not even close to suggesting that monetary policy is or is about to become tight. 

As a first-pass estimate, the Federal funds rate needs to at least equal the rate of inflation for monetary policy to become restrictive. If short-term rates are below the level of inflation, that by itself serves to weaken the demand for money (and encourage borrowing), thus allowing inflationary psychology to persist. If we don't see the growth of M2 start to decline soon (it's currently growing at double-digit rates), then you can expect to see inflation of at least 7% for some time to come. Unfortunately, the Fed only releases data on the money supply once a month; we will have to wait a few more weeks to see what happened in January.

Chart #2

Chart #2 shows the bond market's expectations for the future course of inflation (green line). Right now the market expects the CPI to average about 2.8% per year for the next 5 years. That's somewhat above the Fed's target, but only modestly. That means the market realizes inflation is going to be above average for the next few years, but the market is still convinced the Fed is not going to lose control of the situation. (The Fed defines "losing control" as "inflation expectations becoming unmoored.") I'm all for trusting the Fed, but I like to verify as well, and so far, they are failing on that score.

Chart #3

Chart #4

Small businesses far outnumber large businesses, so it's important to track what the owners of small businesses are thinking. That's shown in Chart #3, which measures the general level of optimism among small business owners. Optimism has fallen in recent years, but is only marginally lower than its long-term average. Things could be better, but they're not terrible yet. The economy is still quite likely to continue growing, since job openings are exceptionally plentiful, and there are still plenty of people willing to go back to work, as shown in Chart #4. Things could be a lot worse. 

Chart #5

Chart #5 shows the major problem cited by a majority of small businesses: prices are rising big-time. 

Chart #6

Over one-fourth of small businesses report paying their workers more (see Chart #6). Although the number dipped last month, it is still exceptionally high. As Chart #5 also shows, inflation today shares a lot in common with inflation in the late 1970s. 

Chart #7

It's rather impressive that a wide range of prices—industrial metals, agriculture prices, energy prices, home prices, etc) are up, and up significantly. In the past two years, many almost doubled in price. Chart #7 shows raw industrial commodity prices (red line) that have increase almost 50% since just before Covid hit. It's also interesting to note that in the past, commodity prices tended to move inversely to the strength of the dollar: a strong dollar depressed prices, while a weak dollar helped drive prices higher. These days that relationship seems to have reversed: the dollar is relatively strong, but prices are surging. I think this reflects a lot of excess money coupled with a general revival of the many activities (e.g., construction, new plant and equipment) that were put on hold during Covid. 

Chart #8

Chart #8 shows 2-yr swap spreads in the US and the Eurozone. Swap spreads are a highly liquid indicator of a) general liquidity conditions, b) the health of the economy, and c) the outlook for corporate profits. US swap spreads currently trade about smack in the middle of what might be considered a "normal" range. Eurozone swap spreads are a bit elevated, which probably reflects the fact that the outlook for the Eurozone economy is decidedly less optimistic than the US. No surprise there: the US stock market has outperformed the Eurozone stock market by some 85% in the past decade. A normal level of swap spreads here suggests abundant levels of liquidity and signal a healthy outlook for the economy and corporate profits.

Chart #9

Finally, Chart #9 shows 5-yr Credit Default Swap rates. Like swap spreads, these are highly liquid indicators of the outlook for corporate profits. Although spreads have risen a bit (out of possible concern that the Fed might tighten too much or too fast), they are still well within what might be considered a normal range. The Fed has yet to inflict any damage on the economy's fundamental indicators.