Wednesday, December 21, 2022

Higher interest rates have solved the inflation problem

As I've been pointing out for over two years, rapid growth in the M2 money supply is a big deal, and one that has not received much attention, if any. At first (i.e., mid- to late 2020) it was OK, because the public felt comfortable holding on to large amounts of cash in their bank deposit and savings accounts at a time of great Covid-related uncertainty and economy-wide lockdowns. But starting early last year, when the worst of the Covid panic was subsiding and life was beginning to get back to normal, people began spending that money. Soon, a flood of spending collided with supply shortages and a still-crippled economy, and the result was higher prices. By the end of last year, inflation was galloping towards 10% or so, but the Fed ignored it, asserting it was merely "transitory." It wasn't until March of this year that the Fed began to get worried. True to form (unfortunately), the Fed was—once again!—late to the inflation party, and they have been trying to catch up ever since. As we now know, they embarked on an impressive series of rate hikes which took short-term rates from 0.25% last March to now 4.5%. That marked the most aggressive monetary tightening in history.

Last week the Fed reiterated its intention to snuff out inflation with still more hikes. Sadly, they are now overstaying their welcome at the inflation party, because we know that inflation peaked many months ago. Unfortunately they didn't get my memo on the subject.

The market is rightly concerned to be worried by all of this.

When all is said and done, the Fed has but one job: to keep the demand for money in line with the supply of money. When the supply of money exceeds the demand for it, inflation is the result, as Milton Friedman taught us long ago and which the experience of the past several years shows us. (I should add that, according to their official mandate, the Fed is also charged with maintaining full employment, but we'll put that aside, especially since they now hint that they won't feel comfortable until they see the economy weaken significantly.) 

Beginning early last year, the demand for money fell even as the supply of money (best measured by M2) continued to rise. It's no wonder that inflation rose. In fact, rising inflation confirmed that the demand for money was failing to keep pace with the supply of money. But beginning about 6-8 months ago, when (not coincidentally) the Fed started to raise interest rates, inflation started to decline. This, we know now, was early evidence that the demand for money stopped falling, while at the same time the M2 money supply started shrinking. My recommendation to the Fed, therefore, has been to give the economy time to adjust—they had done plenty enough.

Over the past six months or so, it has become quite clear that higher interest rates have served to bolster the demand for money. No longer are people trying to aggressively spend down their bank balances, because now they can earn a decent rate of interest on their cash. Put another way, the Fed has raised interest rates by enough to once again bring money supply and demand back into balance. It's also the case that supply chain problems have all but dried up. We know all of this because sensitive prices (e.g., housing prices, commodity prices, the value of the dollar and the price of gold) have fallen. Money demand looks to be much more closely aligned with money supply these days.

In the housing market it's beginning to look like interest rates are too high, in fact, as the following charts illustrate. 

Economics is all about scarcity and incentives. Higher interest rates give people an incentive to hold on to cash rather than spend it, and they give people less incentive to buy and hold on to things like housing. To judge from falling home prices and collapsing home sales and residential construction, higher interest rates have REALLY had a significant impact on the demand for money. Any higher and we'll have a recession on our hands—and that is exactly what worries the equity market these days.

Chart #1

Chart #1 compares the level of housing starts (blue line) with an index of homebuilders' sentiment. Not surprisingly, sentiment tends to precede starts. The more optimistic builders are about the housing market, the more likely they are to embark on new construction. The recent collapse of sentiment thus portends a dramatic decline in housing starts.

Chart #2

Chart #2 shows the number of residential building permits, which recently have begun to decline markedly as Chart #1 predicted. Look for further weakness in all these numbers. 

Chart #3

Chart # shows the number of single family home sales, which have collapsed in recent months. A plunge in sales is one of the reasons homebuilders are much less optimistic. 

Chart #4

Chart #4 shows an index of the number of new mortgage applications (first-time buyers seeking a mortgage to purchase a home). This also has plunged, down by over 40% so far this year.

Chart #5

Chart #5 shows the reason why all this is happening: 30-yr fixed mortgage rates have more than doubled in the past year. Never before has a shock of this magnitude occurred in the housing market. Higher mortgage rates on top of rising home prices have increased the cost of home ownership by an order of magnitude. And why have rates soared? Because the Fed has jacked up interest rates by several orders of magnitude and this has pushed up interest rates across the yield curve. Soaring interest rates have crushed the bond market and this in turn has led to many investors scrambling to hedge themselves against further rate hikes. No one wants to own 30-yr mortgage paper if rates rise further, because that means refinancings will grind to a halt and that paper will acquire a significant amount of duration risk: the value of a fixed rate mortgage will decline by more than about 10% for every 1 percentage point increase in mortgage rates.

As a result, the spread between mortgage rates and 10-yr Treasury yields has widened to just about its widest point ever, over 300 bps. Everything is working against the housing market. 

Does the Fed really want to crush the housing market by hiking rates further? I think they will come to their senses pretty quickly and back off of their recently-announced tightening pledge. The demand for money is soaring and that means inflation will continue to decline. Nobody needs higher rates right now.


The Smoky Mountain Hiker said...

Scott - thanks again for your insightful commentary. I would love to hear your take on what happened with the revisions to the Q2 jobs number, as brought to light by the Philly Fed earlier this week. To this "pedestrian" observer, this seems to be a big deal. By overstating added jobs by more than 1.1 million, did the Fed just raise interest rates on apparently false data - data that supposedly showed that the economy was still running a little too hot? Or is this really a nothingburger that had little impact on the Fed's decision making?

Certainly, this undermines the public trust in gov't data, no?


Scott Grannis said...

Smoky: No intelligent observer doubts that public trust in government data and government dictates has been undermined in recent years. But the proposed revisions to the jobs number you cite are not necessarily egregious. I have addressed this issue in the comments to the previous post, as has my friend Brian Wesbury, whom I also reference.

Salmo Trutta said...

re: "The demand for money is soaring and that means inflation will continue to decline."

The paradox of thrift? Dr. Philip George calculates the demand for money as m1 minus -- to get the "corrected money supply".

That perhaps is why R-gDp in the 3rd qtr. of 2022 was revised up to 3.2%

John A said...

Your Chart #5 says Chart #1 above it.

Scott Grannis said...

John A: thanks for spotting that typo! Now fixed.

steve said...

You fail to mention the strength of the employment numbers which have barely budged and the wage growth is still unacceptably high for Powell and truth be told there is zero chance of coming anywhere near 2% inflation without some comeuppance with these forces. I expect the Fed to continue its rate increases beyond market expectations. Furthermore, investor polling shows a 2/3 expectation of recession within 12 mos. There is too much strength in the economy for that therefore the Fed will not start decreasing rates in '23 as the markets anticipate. Given that stocks hate uncertainty/surprises '23 will be challenging and interesting.

Salmo Trutta said...

See also:

The nominal economy leads – by Marcus Nunes – Money Fetish (

re: "The demand for money is soaring and that means inflation will continue to decline."

Scott Grannis said...

steve: your comment articulates well the mainstream thinking at the moment. The majority of people just can't seem to rid themselves of the notion that the economy must weaken in order for inflation to fall. It just doesn't work that way. Consider the last 6 months: the economy has picked up steam (Q1 growth -1.6%, Q2 -.06%, Q3 3.2%, and the Atlanta Fed GDP Now estimate is currently 3.7% for Q4), yet inflation has fallen significantly! The 6-mo. annualized growth of the Personal Consumption Deflator has dropped from a high of 8% in June to 4% in November. And the 6-mo. growth rate of the Core Personal Consumption Deflator has dropped from a high of 5.2% in June to 4.4% in November. It is overwhelmingly the case that inflation has fallen even as the economy has strengthened.

gkaufman said...

Scott, even if the FED pauses interest rate hikes, they are still engaged in quantitative tightening. What is the effect on the economy? on inflation? How does it compare to changing the interest rates? More influential? Less? Your insight would be appreciated. Thank you.

steve said...

Merry Christmas to all!

Scott, you don't need to convince me. Send a note to Jay. But riddle me this; will inflation fall back to close to 2% without help from the employment forces?

Ranking Hero said...

Hey Scott! 👋 Just finished reading your recent post on how higher interest rates have tackled inflation, and I must say, your analysis is both insightful and thought-provoking.

Your ability to distill complex economic concepts into digestible insights is impressive. The way you outlined the relationship between interest rates and inflation, backed by historical context, really helped me grasp the bigger picture. It's refreshing to see someone take a nuanced approach to these economic discussions.

I appreciate the optimism you've injected into your analysis. It's easy to get overwhelmed by economic challenges, but your perspective on how higher interest rates can be a solution rather than a problem provides a much-needed counterpoint. Your blog is becoming a go-to source for me to make sense of economic trends. Looking forward to more of your enlightening posts! 🌐💡

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