Wednesday, July 13, 2022

Why today's CPI release was not a shock

I write this from Italy, so it's going to be short. Today the CPI surprised to the upside. On a year over year basis, the CPI rose 9.1% vs. an expected increase of 8.8%. The Core CPI (ex-food & energy) was a lot less scary, rising 5.9% year over year vs. an expected 5.7%.

Despite there being some rather strong prints (over the past six months, the CPI is up at an annualized rate of 11.1%), the dollar so far is unchanged, 10-yr T-bond yields actually fell a bit (and at 2.9% are still far below inflation), and gold rose only $19/oz, and it is still way below its all-time high of $2032/oz two years ago. Moreover, inflation expectations today are unchanged from yesterday and are relatively modest: 5-yr breakeven inflation rates are 2.5%, and 10-yr BE inflation rates are 2.3%. And as I write this, the stock market is down only 0.5%.

Why is the market so nonplussed? My friend Don Luskin and I both believe it's due to the dramatic deceleration of the M2 money supply since late last year. 

The above chart plots the year over year growth of M2 (white line) and the year over year change in the Core CPI index (orange line). Note in particular that there is about a one-year lag between big changes in M2 growth and big changes in inflation. M2 surged beginning in March 2020, and the CPI started surging about a year later. Then M2 growth started decelerating in March 2021, and the CPI started to fall in April 2022.

Note: I think it's legitimate to use core CPI, because energy prices have been an order of magnitude more volatile than just about any other prices in recent years.

Given that M2 growth has been almost zero for the past 5 months, this exercise would suggest a strong likelihood that we will continue to see Core CPI inflation decelerate in coming months. None of this, of course, is a secret; anyone can run these numbers, and you can bet there are lots of folks in the bond market that have been watching these numbers like hawks for months. That would explain today's lack of surprise.

This theory is also consistent with what I've been suggesting in recent months, which is that this round of Fed tightening will be unlike any other in the past. Why? Because the surge in M2 was a one-off event and it is already history. The market is adjusting to the expectation that the Fed is doing the right thing (i.e., not panicking, but adjusting short-term rates higher in a prudent manner).

Furthermore, this all suggests that the Fed won't need to tighten dramatically or strangle the economy, as it has in the past. My recent posts provide more grist for all of this.

The economy is likely going to survive this bout of inflation without serious consequences. It will be painful for many, to be sure, but the economy needn't collapse.


Unknown said...

Are you saying that despite a inverted 2-10 year , don't expect a recession?

Scott Grannis said...

I've noted many times on this blog, going back so far I can't remember, that while yield curve inversions have always preceded recessions, by themselves they are not sufficient to predict recessions. You also need to see other things happening, like high and rising real interest rates (which are still very low and even negative), and high and rising credit and swap spreads. 2-yr swap spreads have actually fallen by half in recent weeks, which suggests that liquidity is still abundant—and it's tough to see a recession happen when there is no shortage of liquidity.

Also, the part of the yield curve that is best to focus on—the 1 to 10 year area—has only today inverted (slightly). The 3-mo. T-bill to 10-yr T-bond part of the curve is also relevant to focus on, and it is still positively sloped (+63 bps). In any event, the historical lags between curve inversions and recessions have been long and variable.

I don't mean to say a recession is impossible, I simply think that the risk of a recession is likely lower than most people these days think.

WorthF said...

Scott - I always appreciate your wise counsel. While I agree with your general assessment do you think the 28% of "extra" money supply baked into the system along, with energy constraints baked into the system from Biden & other autocrats bent on curing us of Oil/Gas/Coal and a lagging housing/rental price still to drive higher in the CPI, will not push this CPI reading for longer-and-higher than the market expects at 2.5%? To many of us small and few non-Keyensians, price matters and this generation has lost most moorings to reasonable price. (prime example - inflation expectations at 2 and then 2.5% for the next 5 years & unicorns not discounted for higher than 3% inflation for the next 5+ years).

I know there is no way to accurately answer my question about the future, but when the market is pricing in 2.5% inflation expectations for the next 5 yrs, I am investing for a world were we are considerably over that number (say 3.5% to 4%) versus significantly closer to that current expectation.
BTW - thank your wife for me, for allowing you to post while you enjoy all that Italy has to offer. Safe travels - advisor fan in Bellevue, WA

Ataraxia said...

Why do feel this M2 surge policy/tool will not be the last.

Unknown said...

Not sure the Fed is following this script. What they should do and are doing are different things altogether. They seem determined to be fighting yesterday's news, and expectations are that they will overshoot with their rate increases.

Michael McGaughy / 麥德安 said...

Another very interesting post. Really love your work! Enjoy your vacation.

KB said...


In full agreement with your views on the Fed and the reduction in M2. My concerns are about secular events such as the sharply higher energy costs and supply reductions we have seen in Germany. Seems as though that has to slow their economy. Their largest utility Uniper has applied for government aid to deal with this liquidity crisis.

I believe the Ukraine War has caused other dislocations in areas as diverse as oil or wheat or the international payment system. Could these result in a systemic failure in the banking system?

Kurt Brouwer

Scott Grannis said...

KB: Let's suppose the bulge in M2 never existed (i.e., that M2 had continued to grow at its historic average rate of about 6% per year over the past two 2+ years), and that the world suffered an energy and supply-chain shock because of Covid-related governmental actions. Would inflation have been over 10% for the past two years? I would argue "no."

Without a monetary expansion in excess of the usual, it would have been highly unusual for the general price level to have risen by more than 2% per year. Higher prices for energy would have depressed demand for other things, for example. A stable monetary environment is equivalent to putting the economy on a fixed spending budget.

Supply shocks cause the prices of some things to rise, but not for the prices of all things to rise. A rise in the general price level (all things rising) requires an exceptional increase in the amount of money.

A big energy shock, regardless of whether it coexisted with a monetary surge, would very likely disrupt the economy by forcing prices of other things to decline and thus it would likely produce contractionary effects on the economy. And as you say, this could lead to banking failures. But these might be mitigated if accompanied by excessive monetary expansion.

Adam said...

After CPI report, Nomura expects 100 bps rise in July.

Thomas said...

Rising USD, falling EUR: It must be great being in Italy now! Hope you enjoy your stay there!
Best regards from Austria,

p.s.: thank you for posting during your holidays. Highly appreciated!
p.p.s.: Due to the temperatures in neighbouring Italy the deteriorating gas supply from Russia shouldn't be any problem.

george said...

Spero che ti stia godendo la bellezza, la cucina e la storia d'Italia. E, naturalmente, i benefici che gli americani hanno con il crollo dell'euro.

Your analysis as usual is very good but exclusively on the US. Is your time abroad now changing that? M2 has certainly had a huge one off surge that has now dropped back, but the dollar is now having an equally profound rare event, it is soaring. Gold Is down 15% in dollars from its all time highs, but the US$ is up about 15% since the beginning of the year. Virtually everywhere else in the world gold is at or near an all time high. The same correlation can be made with most prices in the rest of the world where inflation is accelerating. With massive debt, much in US$s the world (especially Italia) can’t raise interest rates as it could cause default. If the US continues to raise rates and world doesn’t, the Sri Lanka story will be repeated again and again, which will force the Fed to reverse course too soon.

That scenario supports my view that world government and public debt is so overwhelming that the only solution is to debase currencies via inflation worldwide of hopefully 10%/year for several years.

Please feel free to point out areas where I am wrong or making questionable analysis. And of course enjoy the great red wine.

Tom L said...

Thanks Scott and enjoy your time in Italy and a strong dollar. Here's a good clip from Milton Friedman reminding me of what you are saying

Winston said...

Scott, even if the growth of M2 has gone flat, we still have that big increase in the system do we not? What if anything is the Fed doing to soak up the excess M2 already in circulation? Are they actively selling off assets or just letting assets run off as they mature? Is the latter enough?

Salmo Trutta said...

The 24-month rate-of-change in our means-of-payment money supply is about 2.5x higher than any historical figure. But by the 4th qtr. of 2022 it crashes down.

marcusbalbus said...

last refuge of pangloss: tracking m2, q a metric woefully inadequate and largely relegated to the dustbin by most deep thinkers. inflation is embedded more and more; credit creation cares not about m2

Unknown said...


Can you show cumulative change in money supply against cumulative CPI, say since 2012 or 2016.
the reason is, when you have a 5% increase in money supply in Q1 2022 on top of a 15% increase in Q1 2021, I would think that would have a bigger impact on inflation than if that same 5% folllowed 5% from the prior year.

Andrew said...


My concern is that the growth of M2 has been so great, that M2 as a percentage of GDP is far higher than it ever was prior to COVID.

Prior to COVID it was not much more than 70%.
Currently, it's about 87%

Np clear, what an acceptable value would be ...

Salmo Trutta said...

No one understands money and central banking. Money has no significant impact on prices unless it is being exchanged.

From the standpoint of the system, banks don't lend deposits. Deposits are the result of lending. Bank-held savings have a zero payment's velocity (somewhat like remunerated IBDDs which are inert).

The only way to track R-GDP and prices was to track required reserves (as reserves were driven by payments). There was a perfect connection between required reserves and both R-gDp and prices (which nobody knew). That's how I predicted both the flash crash in stocks and the flash crash in bonds. Now, Powell has eliminated them. The FED is operating without an anchor or a rudder.

Salmo Trutta said...

BEA: “Real gross domestic product (GDP) decreased at an annual rate of 1.4 percent in the first quarter of 2022.” GDPnow’s latest estimate: -1.5 percent — July 15, 2022

That can only be true if O/N RRPs drain liquidity, i.e., reduce the money stock. A change in the “demand for money” is insufficient. The FED’s economists are contradictory.
Link: “Understanding Bank Deposit Growth during the COVID-19 Pandemic”

“According to Greg Ip, money supply had a poor record of predicting US inflation because of conceptual and definitional problems that haven’t gone away.”

“since the early 1980s, correlations between various definitions of money and national income have broken down” – Frank Shostak of The Mises Institute

That’s not how the economy worked. The rate-of-change in legal reserves determined national income. “Black Monday” was due to the largest swing in RRs since the GD. And it’s not something you can run a regression test against. The FED covered its Elephant Tracks.

That’s why the stock market bottomed in October 2002 and in March 2009.