More thoughts on the banking crisis

By calling into question the value of a significant portion of the country's bank deposits, the recent failure of one or more regional banks is equivalent to a sudden tightening of monetary policy, in which the supply of money is perceived to have contracted while the demand for the remaining portion has increased.

Background: The "ideal" money can be defined as a highly liquid, universally-accepted medium of exchange that holds its value over time and can—but not necessarily—also pay a floating rate of interest, e.g., currency, checking and demand deposits, and retail money market funds. M2 incorporates all of these and is thus an excellent way to track the supply of money.

Therefore, we might say that the current banking crisis is being caused by the perception that some portion of M2 (e.g., bank deposits in regional banks) may lose—or may have already lost—value in the event of a bank failure or expected bank failures. That perception automatically triggers an increased demand for the rest of M2. Together, this has the same effect as a sudden tightening of monetary policy; the supply of money has decreased at the same time the demand for money has increased.

If the Fed does not offset this effective tightening by reducing interest rates, things could get ugly. Reducing interest rates does two things: 1) it makes holding money less attractive on the margin, and 2) it makes borrowing money more attractive on the margin. This serves to reduce the demand for money while at the same time increasing the supply of money (because an increase in loans expands the supply of money). Together they amount to a relaxing of monetary policy, and that is the appropriate response to a sudden and unexpected tightening of monetary policy.

The Federal Open Market Committee (FOMC) meets on Wednesday, March 22, at which time they are expected to make what is now an extremely important decision: will they raise rates, hold rates steady, or cut rates? The market seems to expect they will most likely hold rates steady. I would argue they should cut rates, as my argument above suggests, and I hope they do.

Some helpful charts for background follow:

Chart #1

Chart #1 shows the inflation-adjusted value of the dollar relative to a trade-weighted measure of other currencies. By any measure the dollar is strong, and significantly stronger than it has been for most of the past half-century. Judging by this evidence, the dollar is still the world's premier currency. We could also infer that there is no excess supply of dollars relative to the world's demand for dollars. This further suggests that a sudden tightening of US monetary policy (as described above) could boost the dollar's value further, thus negatively impacting nearly every other currency on the planet. A strong currency is very important, as is a stable currency. A strong and appreciating currency is not necessarily a good thing.

Chart #2

Chart #2 compares the value of the dollar (using a popular but less robust measure of the dollar's value than that used in Chart #2) to the inflation-adjusted price of gold. (Note: I have inverted the dollar, so a falling blue line represents a stronger dollar.) If the dollar and gold were competing "safe ports in a monetary storm" then a stronger dollar might coincide with a lower gold price, and vice versa. That has been the case of many years, as the chart suggests. In recent years, however, the dollar has appreciated alongside a rising gold price. Is the dollar "too strong," or is gold "too strong?" I don't have a good answer to that, unfortunately.

Chart #3

Chart #3 shows the level of the Fed's balance sheet. Last week, the Fed's balance sheet jumped by about $300 billion, the result of the Fed extending credit to troubled banks in exchange for those banks posting notes and bonds as collateral for an emergency loan. Did the supply of money also increase? We won't know the answer to that question until the release of March M2 statistics on April 25th. I would also note that there has been no appreciable shrinkage in the Fed's balance sheet despite their professed intention to do so.

Chart #4

Chart #4 shows the level of bank reserves held on deposit with the Fed by the nation's banks. For decades prior to 2008, bank reserves were only a tiny fraction of what they are today. That's because bank reserves paid no interest prior to 2008, and banks were required to hold reserves in order to collateralize their deposits. Thus, banks held only the absolute minimum amount of reserves they were required to hold. After 2008, the Fed began paying interest on reserves, and so banks came to view reserves as a valuable asset: highest quality, risk-free, default-free, and paying a floating rate of interest. In short, reserves came to be viewed as functionally equivalent to T-bills, and banks were happy to load up on their holdings of reserves. 

By any measure, and from an historical perspective, there is an abundance of bank reserves today. The Fed is not significantly restricting the supply of this very important asset like they did prior to 2008, when the Fed intentionally restricted the supply of reserves in order to boost market interest rates (banks that wanted to expand their lending were forced to borrow reserves from other banks, and that boosted short-term interest rates). That is one good reason to think that the banking system and financial markets today are more resilient than in prior Fed tightenings.

Chart #5

Chart #5 shows the level of 2-yr swap spreads. (See my swap spread primer here.) This is an all-important measure of liquidity in the banking system (the lower the spread the greater the liquidity) as well as the financial health of the economy (the lower the better). Note that in the wake of the SVB crisis, swap spreads have fallen. This dovetails with Chart #5 in the sense that both suggest that there is abundant liquidity in the banking system, and that's a very good thing.

Chart #6

Chart #6 shows the level of Credit Default Swap spreads, which is a very liquid and generic indicator of the market's perception of the health of corporate profits, and by inference the health of the economy. These spreads have risen somewhat in the wake of the SVB crisis, but not significantly, and that's a good thing, since it means the economy is not likely on the cusp of recession.

Chart #7

Chart #7 shows the level of nominal and real 5-yr Treasury yields and the difference between the two, which is the market's expectation for what CPI inflation will average over the next 5 years. By this measure, the market is saying there is almost no problem with the outlook for inflation. Whatever the Fed has done to date has been sufficient to tame the inflation beast that awakened (unexpectedly, for those who have not followed this blog) over a year ago. 

Chart #8

Chart #8 shows the year over year and 6-mo. annualized rate of change in the Producer Price Final Demand index (i.e., inflation at the wholesale level). Both measures have dropped significantly from their peaks of last year. This is a good approximation of what we likely will see happening with the CPI over the course of this year. 

Swap and credit spreads say no recession

Today the market was rattled by news that Silicon Valley Bank (SIVB) was forced to sell most of its bond portfolio at a nearly $2 billion loss and will now have to raise additional capital to remain solvent. The question on everyone's mind: is this the first inning in a replay of 2008's financial crisis? Aggressive Fed tightening over the past year or so has devastated the value of bond portfolios because interest rates have risen by more and faster than during any prior bond bear market. To make matters worse, Chairman Powell two days ago declared that the Fed may well have to raise rates by even more than they expected, in large part because the economy is proving stronger than expected.

So what is it? Will the SIVB collapse mark the beginning of another financial crisis which in turn triggers the long-awaited recession? Or is the economy so healthy that the Fed will need to raise rates even more? Inquiring minds would like to know how these two fears can coexist.

I don't pretend to know the answer, but I do know that—outside of the now-famous inverted yield curve—it's difficult to find any signs that a recession is around the corner. A big disappointment in tomorrow's jobs number might persuade me to become less complacent, however.

I also know that, thanks to the decline in M2 and today's much higher interest rates, inflation pressures peaked some months ago and inflation is quite likely to decline over the course of this year as it returns to the Fed's 2% target. Following are some charts that round out the story:

Chart #1

Chart #1 shows the level of 2-yr swap spreads in the U.S. and Europe. These spreads have an uncanny ability to predict the onset and end of recessions (higher spreads predict bad news for the economy, and lower spreads predict better news). Eurozone swap spreads are still elevated, but they have come down significantly in recent months—thank goodness. U.S. swap spreads are only modestly elevated (a "normal" range would be roughly 15 to 35 bps) and they too have been declining of late. No signs of a recession here.

Chart #2

Chart #2 shows the level of corporate credit spreads. Like swap spreads, these too tend to predict the beginning and end of recessions. Current levels reflect substantially "normal" conditions. The bond market is signaling that the outlook for the economy is generally healthy, and liquidity conditions are good. No signs of a recession here.

Chart #3

Chart #3 is another way of looking at the spreads in Chart #2: the line represents the difference between high-yield and investment-grade spreads, otherwise known as the "junk spread." Here it becomes perhaps clearer that conditions today are pretty normal.

Chart #4

Chart #5

Charts #4 and #5 focus on Credit Default Swap Spreads, which are highly liquid and quite representative of generic credit risk. Here too its difficult to see signs of distress. 

Chart #6

Chart #6 shows the level of 30-yr fixed mortgage rates. Never before have they risen so much in so short a time. This has caused profound distress in the nation's real estate market. Real estate is the one area of the economy that is really suffering, but as the previous charts suggest, this suffering has not been contagious to the broader economy. One positive thing to note is that there is not a large overhang of new construction or a significant inventory of homes for sale (like we had in 2005-2006). The solution to the current real estate problem is not a collapse but a repricing: housing prices went up too far given the simultaneous surge in financing costs. The solution is simple, but it may take awhile to play out: prices need to fall and interest rates need to decline.

There is one good thing to note here: higher interest rates are having a big impact on asset markets, which in turn implies that Fed tightening is working. The Fed doesn't need to do much more, if anything.

Chart #7

Changing the subject, Chart #7 shows a very important macro statistic that is generally ignored by the financial press. Households' real net worth fell by about 9% last year, but it is not out of line with historical experience. As the green line suggests, this measure of our nation's well being has improved by about 3.6% per year for many decades, and the current level of real net worth is right in line with the long-term trend: $148 trillion.

Chart #8

Chart #8 is remarkable in that the jobs market is apparently more healthy today than it has been in a long time. Job openings are near record highs, and they exceed the number of people looking for work by a record margin. Some employers are shedding workers (e.g., the tech sector), but most others are having difficulty finding people willing and able to work. This is not the sort of situation that precedes recessions.

M2: the smoking gun of inflation

Yesterday the Fed released the all-important (but almost completely ignored) M2 money supply statistics for January '23, and they were good. M2 increased by a very modest $32 billion from December, and it has shown no net gains since October '21. Year over year M2 growth is -1.7%, and 6-mo annualized growth is -3.4%.

M2's huge growth from 2020 through 2021 provided the fuel for the inflation that has rocked the economy for the past year, and it's great news that it's fading away. The growth of M2, by over $6 trillion in two years, was the result of the monetization of roughly $6 trillion of Treasury debt issued to fund a tsunami of federal transfer payments in that same period. Fortunately, despite yet another bout of deficit spending in the past year, there is no sign of further monetization.

It is still mind-boggling to me that the unprecedented growth of M2 has almost completely escaped the public's notice. Most surprising of all: how in the world could the Fed not see it? Why was there only a handful of economists who commented on it, as I noted a year ago? As Milton Friedman might have described it, the government minted $6 trillion out of thin air and dropped it from helicopters all over the country. How could that not have resulted in higher prices? 

In any event, here we are; the flood of funny money is receding. That's why there is now plenty of light at the end of the inflation tunnel.

Chart #1

Chart #1 is the main attraction. The M2 money supply exploded from $15.5 trillion in February '20 to $21.5 trillion in January '22. Since then, M2 growth has turned negative, and today M2 is only $3.4 trillion above where it might have been in the absence of the Fed's "helicopter drop." The gap is closing, and the money printing presses have been shut down. Inflation pressures peaked almost a year ago, and headline inflation will almost certainly continue to subside. 

Chart #2

Chart #2 shows the 6-mo. annualized growth rate of M2, which is now -3.4%, down sharply from a high of over 40% in August of 2020. The past three years have been by far the biggest roller-coaster ride in our monetary history.

Chart #3

Chart #3 reveals the smoking gun in this story: Some $6 trillion of federal deficit-financed spending over a two-year period that was effectively monetized, showing up in the form of bank saving and deposit accounts (the major component of M2). At first this was fine, because the public was not willing or able to spend it—the demand for money was intense. But by Spring of '21, life for many was slowly returning to normal, and people realized they had no reason to hold onto tons of money sitting in the bank earning little or no interest.  Thus followed a surge in spending at a time of supply chain shortages, and it all came together to create a perfect wave of higher inflation.

Chart #4

Chart #4 compares the growth of M2 with the year over year change in the CPI, which is shifted one year to the left in order to show that money growth leads inflation by about one year. This chart further suggests that the year over year change in the CPI will gradually fall to the Fed's 2% target over the course of this year, thanks to the huge deceleration in M2 growth over the past year.

Chart #5

Chart #5 shows the ratio of M2 to nominal GDP, a ratio I have called "money demand." Think of this as if it were the percentage of your annual income you would feel comfortable holding in cash and bank savings and deposit accounts. Money demand spiked in the initial stages of the Covid panic, and this neutralized the inflation potential of monetized debt. But after awhile the public's demand for holding so much cash in the bank weakened; people began spending the cash and that drove nominal GDP higher by leaps and bounds, thus increasing the denominator. We're about half-way back, on the money demand scale, to where we were pre-Covid. Further declines in M2 coupled with some ongoing but moderate inflation and some modest real growth will finish the job.

Chart #6

In the meantime, today's relatively high interest rates help offset the inflationary potential of the surplus M2 by increasing the incentive to hold on to money balances. Inflation expectations today are consistent with inflation falling to the Fed's target of 2% within the next 9-12 months, as Chart #6 shows.

The Fed doesn't need to do more than they already have. The lower-inflation wheels have been set in motion.

Inflation fears are overblown

Stock market bears are fixated on the belief that inflation is not only "running hot" but also "accelerating." Nothing could be further from the truth. 

Some charts that help put things into perspective:

Chart #1

Chart #1 shows that existing home sales have fallen by 36% in the past year. This is extraordinary. Given the lags in reporting this data, the reality is likely worse. We are in the midst of dramatic weakness in the housing sector. 

Chart #2

Chart #2 shows the likely culprit: a once-in-a-lifetime surge in the cost of borrowing money to buy a house. 30-yr fixed rate mortgages are now back to 7%, which is more than double the level that prevailed just over a year ago. Combined with rising home prices, this has increased the cost of buying a house by at least one-third in a very short time span. It's likely that the market has not yet had time to fully adjust to this new reality. It can only mean further weakness in the housing market.

Chart #3

Chart #3 shows that applications for new mortgages have dropped an astonishing 58% in the past year. The Fed missed the signs of rising inflation (they should have been watching M2 growth years ago) and now they have slammed on the brakes and are talking tough. Sharply higher interest rates, in turn, have dramatically affected the public's ability and willingness to buy a home. There is no question that monetary policy has had a dramatic impact on the real economy and on prices. Conclusion: the Fed should stand pat and watch how things evolve from here. 

Chart #4

Chart #4 compares the level of 30-year fixed mortgage rates (white line) with the 10-yr Treasury yield (orange line), and the spread between the two (bottom half of the chart). This is what happens when bond yields surge unexpectedly: investors in bonds and mortgages have been burned (it's been the worse bond market in many lifetimes) and now they are twice shy. Demand for these securities has collapsed, pushing mortgage rates to an almost-unprecedented level above that of 10-yr Treasury yields. Normally this spread would be about 150-200 bps, but now it's over 300. The bond market has amplified the Fed's tightening efforts. It's VERY expensive to borrow at fixed rates these days.

Chart #5

Chart #5 shows that natural gas prices have truly collapsed, falling by way more than ever before in a short span of time. Traders say it's due to warm weather in the East. Regardless, this is an important source of energy for vast swaths of the economy, and it equates to a powerful deflationary force. And let's not forget that oil prices have plunged 35% from their highs last May. It's not just the weather; commodity prices are down across the board over the past 6-12 months. Monetary policy is undoubtedly one of the reasons. 

Chart #6

Chart #6 tells us that the bond market feels pretty good about the outlook for inflation. The spread between 5-yr Treasuries and 5-yr TIPS is now less than 2.5%, which means that the bond market expects the CPI to average less than 2.5% per year for the next 5 years. Higher interest rates have convinced bond traders that the Fed has done enough. Chairman Powell, are you listening?

Chart #7

Chart #7 compares the relative prices of services, non-durable goods, and durable goods. What an amazing divergence! Service prices are largely driven by wages, and durable goods prices have fallen thanks in large part to Chinese exports (which began to get underway in 1995). Durable and non-durable goods prices have been flat for the past 5-6 months, while service sector prices continue to rise. The Fed presumably worries that wages and low unemployment rates will continue to drive inflation higher. Do they really want to see bread lines showing up all over the country? Wages don't cause inflation: they are driven by productivity and the imbalances between the supply and demand for money. 

As for productivity: since 1995 service sector prices have increased 3 times more than durable goods prices! In rough terms, that means that one hour of the average worker's time today buys 3 times as much in the way of durable goods than it did in 1995. No wonder nearly everyone is able to afford to carry a super-computer, high-end camera, and internet connection in his or her pocket.

Chart #8

Chart #8 shows the year over year changes in the Personal Consumption Deflators (with the Core version being the Fed's favorite measure of inflation). Both rates came in a few tenths of a percent higher than the market expected. Does that sound like inflation accelerating? Or running hot? No. Inflation pressures peaked many months ago. Both of these measures are on track to show year over year gains that are much lower than their current level. It takes time for monetary policy–which is undoubtedly tight—to work its way through the economy. We just need to be patient.

Next Tuesday we'll have the all-important release of the January M2 money supply number. I expect it will show a continued decline, which will strongly reinforce the outlook for slowing inflation in the months to come. 

Inflation is still under control and the economic outlook remains healthy

Is inflation "running hot" because the January stats on the CPI and PPI were stronger than expected? No. Ups and downs in the monthly data are to be expected, so this is not necessarily something to worry about, especially since the macro picture hasn't changed for the worse at all.

Keep focused on the all-important monetary and macro variables: M2 and interest rates. The M2 measure of money supply is declining, and higher interest rates are increasing the demand for money; this is a one-two punch (an increased demand for a smaller supply of money) which is rapidly snuffing out inflation. Higher rates are having a big impact on the housing market, and the bond market continues to price in low inflation and a positive economic outlook. The dollar remains strong, gold is weaker on the margin, and commodity prices are soft. The result of all of this is that inflation pressures are declining on the margin.

One of the biggest factors behind the January CPI surprise was Owners' Equivalent Rent. Housing is a big component of CPI and it's been very strong of late, but this is almost certainly going to reverse later this year. Meanwhile, there is still no sign of the kind of economic or financial market stress that would trigger a recession.

And now some charts to round out the story:

Chart #1

Chart #1 compares the rate of increase in housing prices (blue line) with the rate of increase in the so-called "Owner's Equivalent Rent," (red line) which comprises more than one-third of the CPI. I've shifted the red line about 18 months to the left in order to show that changes in housing prices take about 18 months to show up in increases in OER. This means that the 2021 increase in housing prices is now boosting the CPI today, and this will likely be the case for at least the the next several months. But the chart also shows that there has been a significant slowdown in the rate of home price appreciation which began almost a year ago, so at some point—later this year—the OER component of the CPI will drop considerably. Worrying about the January "jump" in CPI inflation just doesn't make sense. You have to look at where the CPI is going to be going over the course of this year, and that is very likely to be in the direction of lower inflation.

Chart #2

Chart #2 shows the year over year and 6-mo. annualized rate of change in national housing prices. This adds force to the argument in Chart #1, because over the past 6 months, national home prices have declined. And the latest datapoint for this series (November '22) is based on the average of the previous three months, and prices have almost certainly softened in the most recent 3 months. That will pull the year over year change in housing prices well below zero, so OER will begin to subtract from CPI inflation within 3-6 months.

Chart #3

Chart #3 goes a long way to explaining why housing prices have dropped this past year. 30-yr mortgage rates have more than doubled. In fact, we've never seen mortgage rates increase so fast by so much. In turn, that has dramatically increased the cost of home ownership, on top of the increased level of prices. Housing has become unaffordable to millions of families in a relatively short period.

Chart #4

Chart #5

Chart #4 shows just how much the slowdown in housing has impacted residential construction. Housing starts have fallen 27% since their April '22 high, and homebuilders' sentiment as all but collapsed. As Chart #5 shows, building permits are down 30% since the end of '21, though they have been relatively flat for the past 3 months. It's a meaningful decline, but it's not likely to be a replay of the housing market collapse that led up to the 2008 financial crisis. There has been no overbuilding of homes, and Congress has not encouraged the banks to lend to marginal borrowers.

In short, there has been a massive adjustment in the housing market to higher interest rates, and it's going to put lots of downward pressure on the CPI starting later this year.

Chart #6

As the red line in Chart #6 shows, producer prices in January also surprised to the upside, but I strongly doubt this marks a change in the downward trend. The year over year measure continues to decline, and the 6-mo. annualized rate remains quite low, even though it ticked up in January.

Chart #7

Chart #8

Charts #7 and #8 show other measures of producer prices. They all tell the same story: on a year over year basis, core and total inflation continues to decline. And while the monthly measures ticked up in January, the 6-mo. change in prices remains at relatively low levels. The headlines should read: "Over the past six months, producer prices have been relatively stable." This all but ensures that the year over year measures of PPI and CPI inflation will continue to decline in the months to come.

Chart #9

Chart #9 compares the year over year growth rate of M2 (blue line) with the year over year growth in the consumer price index (red line), the latter being shifted one year to the left in order to show that it takes a year or so for changes in M2 to show up in changes in inflation. The decline in M2 this past year strongly suggests that CPI inflation will continue to fall over the course of this year. Steve Hanke and John Greenwood recently wrote about this in the WSJ, and they echo many of the things I have been saying in this blog. We have been on the same M2 page for a long time. (But I'm not quite as concerned about recession as they are.)

Chart #10

Chart #10 shows the Baltic Dry Index, which is a proxy for dry bulk shipping costs around the world. What it shows is that shipping bottlenecks have almost completely disappeared, and shipping costs have plunged. This augurs well for future world trade and prosperity, as well as lower input costs for many goods. The global economy is most definitely NOT "running hot."

Chart #11

Chart #11 is the Chicago Fed's Financial Conditions Index. Higher values reflect deteriorating conditions, while lower values represent improving conditions. There is no sign here of any impending recession. Ditto for Credit Default Swap spreads and for corporate credit spreads. Liquidity conditions remain healthy, and this argues strongly for healthy economic conditions in general for the foreseeable future.

The Fed's drive to push rates higher has made a significant difference in the inflation fundamentals, because they have dramatically altered the incentives to borrow, spend, and hold money. Higher rates have NOT adversely impacted the economy like they have in the past, moreover. Why not? Because the Fed has limited its tightening to interest rates while leaving an abundance of bank reserves in the system. It's not really the case that money is "tight" in the sense that it's hard to come by. The Fed has responded to the abundance of liquidity (and the 2020-2021 surge in the M2 money supply) by dramatically increasing (using the tool of higher interest rates) the world's incentives to hold on to money rather than to just spend it wantonly. And it's working. 

Recommended reading: Steve Moore's Hotline

I've known Steve Moore since the 1980s, and he's one of the best economists out there, especially when it comes to understanding and explaining the relationship between government policies, the economy, and what creates prosperity. For several years now he has been publishing a daily Hotline newsletter that is always full of must-know facts and figures. And it's free, just for the asking.

Today’s edition features Chart #2 from my last week's post. I used the chart to make the point that bad economic policies have resulted in very slow growth for the US economy for the past 14 years. He translates that into a number that people can more easily relate to: "if we had stayed on the 1984-2004 growth path, the average American would be about 22% richer today – or at least $15,000 more income per median income family."

Once again I would encourage all to subscribe to the Hotline.

GDP up, inflation down

Conventional wisdom these days is that in order for the Fed to bring inflation down, they are going to have to kneecap the economy. So with the Fed continuing to talk tough, it's no wonder that a majority expect to see a US recession some time this year.

Wrong. As I've been explaining for a long time, inflation has already dropped significantly, and the economy remains reasonably healthy. In fact, a healthy economy and a vigilant Fed are a tried-and-true prescription for low inflation.

The facts back me up:

Real GDP growth for Q4/22 came in slightly above expectations (2.9% vs. 2.6%), and inflation, according to the very broad GDP deflator, was also slightly above expectations (3.5% vs. 3.2%), although it was substantially less than the 9.1% rate of just six months ago. Looking back at last year as a whole, real GDP shrank at a 1.1% annualized rate in the first half of the year, and grew at a 3.1% annualized rate in the second half of the year. Inflation, according to the GDP deflator (the most inclusive index we have), was running about 8.7% in the first half of the year, and 3.9% in the second half. So inflation fell by more than half over the course of the second half of the year, even as real growth almost tripled! So much for "conventional wisdom."

Some charts to illustrate:

Chart #1

Chart #1 shows the quarterly annualized change in the GDP deflator, the broadest measure of inflation. Last year it peaked at 9.1% in the second quarter of last year, and fell to 3.5% in the fourth quarter. That's a huge decline that I would wager most people are unaware of.

Chart #2

Chart #2 is also one that I believe most people are unaware of. The blue line represents the size of the US economy in inflation-adjusted terms (aka real growth). It's plotted on a logarithmic axis which turns constant rates of growth into straight lines. The green trend line extrapolates where real GDP would be if the economy had continued its 3.1% trend growth rate that was in place from 1950 though 2007. The red trend line is the 2.2% annual growth trend that has been in place since the recovery started in 2009. What we see in recent years is a perfect example of Milton Friedman's "plucked string" theory of economic growth. It says that the economy tends to grow at a steady rate unless or until it meets a disturbance (e.g., a recession); and once that disturbance has passed, the economy "snaps back" to its former trend line. 

Voilá! The economy is growing at about 2.2% annual rate. Nothing special or surprising about that at all. But the real tragedy is that we could be growing at a much faster rate if our fiscal policy were sane instead of being dominated by burdensome regulations, green energy mandates, and egregious tax rates.

Chart #3

Chart #3 makes yet another appearance—it's one of my favorites. It shows that when the market gets very nervous (as measured by a rise in the Vix index), the stock market tends to swoon. And when confidence returns and the Vix index drops, stocks tend to rally. Confidence these days is slowly returning and the stock market is moving higher. 

Let's hope this continues; let's hope the Fed doesn't feel compelled to squeeze the economy just because inflation is a little higher than they would like to see. The truth is that on the margin, inflation pressures are receding (and by some measures inflation is already back down to 2%—see Chart #1 in this post) and the best way to keep inflation low is to allow the economy to continue to grow while keeping interest rates high enough to keep the demand for money from plunging. A greater supply of goods and services, after all, will help absorb any extra money that is still sloshing around. 

UPDATE (Jan 27): Today we learned that the growth rate of the Core Personal Consumption Deflator for December continued to fall. That's the Fed's preferred measure of inflation. As Chart #4 shows, the 6-mo. annualized rate of growth of this index is 3.7%. The total PCE deflator is up only 2.1% on a 6-mo. annualized basis. Inflation is rapidly ceasing to be a problem. 

Chart #4

M2 news continues to impress

For the past 18 months or so, I have argued that the surge in inflation which began about two years ago was fueled by a surge in the M2 money supply that began in the months following the Covid panic. The M2 surge, in turn, was created by the effective monetization of some $5 trillion of government checks (politely termed transfer payments) sent out to the citizenry, ostensibly to "stimulate" the economy.

As Milton Friedman might have described it, Congress printed up $5 trillion in new cash and hired a fleet of helicopters to drop it all over the country. He would have been surprised, however, that this didn't lead to an immediate surge of inflation. He theorized that people would rush to spend the cash they discovered in their backyards, thus giving inflation, and prices, a one-time boost. But I think he would understand that in this case, people simply stuffed the cash under their mattresses—they were under lockdown and couldn't spend it and, besides, there was so much uncertainty at the time that most people were content to just sit on their cash. For awhile at least. But by early 2021 Covid fears were easing and many people were anxious to get back to their normal lives. They started spending the money they had stashed away, and that was when inflation started to surge.

Today we received the M2 number for December '22, and it showed that the money supply has been shrinking at an unprecedented rate since its peak last March. People are spending down their excess cash balances and paying off loans, and that has been supporting a substantial rise in real GDP and a substantial rise in inflation as well. If the Fed has done anything right in this whole inflationary episode, it is to jack up short-term interest rates in unprecedented fashion (albeit too late); overnight rates have soared from 0.25% last March to now 4.5%. Higher interest rates worked to increase the demand for the excess cash, thus slowing the surge in spending and keeping inflation from exploding. Given the many signs that inflation is indeed cooling—commodity prices are down, real estate sales have ground to a halt, rents are falling, producer price inflation has plunged, oil prices are down by one-third—it looks like Fed rate hikes have substantially offset the inflationary potential of trillions of "excess" money supply.  

Chart #1

Chart #1 shows the growth in the M2 monetary aggregate. Since 1995, M2 had been growing on average by about 6% per year (green line), with occasional mini-bursts of growth which were later reversed. But the Covid helicopter drop saw by far the largest expansion in M2 in history. The peak in M2 occurred last March, at $21.7 trillion, which was $4.7 trillion above its trend growth. Since then M2 has shrunk, and it is now only $3.4 trillion above trend; "excess" money has thus dropped by almost 30%. Over the past six months, the annualized rate of growth of M2 has been -3.7%; over the past 3 months, M2 is down at an annualized rate of 5.4%. This is very good news.

Chart #2

Chart #2 is powerful evidence that the surge in M2 growth was fueled by a massive increase in the federal deficit, which was effectively monetized as people deposited their checks and held on to the funds. Although it's a shame the deficit has started to rise again, it's nice to see that this time it is not being monetized. If Congress fails to reform its spendthrift ways it will be a shame because excessive government spending just weakens the economy. But there is reason to believe it won't aggravate inflation.

Chart #3

Chart #3 suggests that there is a 12-16 month lag between the growth of M2 and the rise in inflation. It further suggests that the significant decline in M2 over the past 9 months means that consumer price inflation is likely to continue to fall for the balance of this year and possibly well into next year, thus meeting the Fed's objective.

Chart #4

Chart #4 shows the public's demand for money, which is proxied by dividing M2 by nominal GDP—think of it as the amount of the average person's annual income he or she prefers to hold in cash and cash equivalents. The inverse of this is commonly known as the velocity of money, which has been surging as money demand has been falling. The chart further suggests that we are likely to see further declines in money demand (and further increases in money velocity) before this is all over. Why couldn't money demand return to its pre-Covid levels? To keep this from happening too quickly (since that would boost inflation), the Fed will need to keep interest rates relatively high for at least the balance of this year. It's nice to know that this is what the bond market fully expects to see—which means we won't be in for any unpleasant shocks.

Federal debt is not as bad as you might think

The federal government has once again run up against its borrowing limits, and it's going to be Silly Season in Washington DC for the next few weeks. The debt limit will obviously have to be raised, but at what cost? None, according to the Democrats; spending discipline according to the Republicans. Sadly, both parties are complicit in the larger problem: Congress continues to spend money like a drunken sailor, and it has been ever thus, as the charts below show. 

Chart #1

Chart #1 shows the staggering growth of federal debt held by the public, which is now $24.6 trillion. It is not $31.5 trillion, as many claim, because that figure includes money that Treasury has borrowed from social security and other government agencies. What the government owes itself is irrelevant; what matters is what our government owes to the public. As the chart shows, debt has been growing at about a 9% annual rate for the past 50+ years. This is not a new problem. (Note: the y-axis is logarithmic, so a straight line equates to a steady rate of growth; a steeper line equates to increases in the rate of growth.) Debt in the past (e.g., mid-1980s, and 2009-2012) has grown at much faster rates than it has recently. 

Chart #2

Fear mongers prefer to compare the size of federal debt to the economy, which is what Chart #2 shows. On this basis, the size of our debt today is greater than at anytime since World War II. It's almost equal to our annual GDP. Yikes! But it's not nearly as bad as this would lead you to think. 

Chart #3

The "burden" of debt is not the nominal amount, nor is it the size of the debt relative to GDP. The true burden is the cost of servicing the debt, which is a direct function of the level of interest rates. As Chart #3 shows, the size of our debt is indeed huge, but interest rates are historically low. Let me point out a curious fact: a rising debt/GDP ratio tends to coincide with falling interest rates, and a falling debt/GDP ratio tends to coincide with rising interest rates. Not what you've been led to believe, I'm sure. 

Chart #4

Chart #4 shows the true burden of our debt, which is the cost of servicing the debt as a percent of GDP. That makes sense for the government, just as it makes sense for those who buy a house with a mortgage: what is your monthly mortgage payment as a percent of your income? A bigger economy can easily handle higher debt loads. But rising interest rates added to a very large nominal debt can be explosive. Fortunately, we're not there yet. In fact, the current burden of our federal debt is historically rather low. Sure, it's going to be rising by leaps and bounds in the years to come if interest rates continue to rise and the government continues to borrow. But maybe we'll get lucky (once again) and Congress will rein in spending and inflation will return to the Fed's target without the Fed having to jack rates to the moon. Our debt burden was about 60% larger in the 80s and 90s than it is today, and the sky never fell. 

The big reason debt rose so much was spending. In the 12 months ended February 2020, federal spending was $4.6 trillion. In the 12 months ended December 2022, federal spending was $6.3 trillion, up 1.7 trillion (36%) from Feb. '20. Taxpayers couldn't keep up the same pace, but the results may surprise you: in the 12 months ended February 2020, federal revenues were $3.6 trillion. In the 12 months ended December 2022, federal revenues surged to $4.9 trillion, up $1.3 trillion (+36%). 

Chart #5

Chart #5 sums it up. Spending in the Covid years exploded, far outstripping the ability of surging tax collections to keep up.

Chart #6

Chart #6 puts things into even better perspective. As a percent of GDP, tax revenues today are somewhat higher than their post-war average, but spending remains extremely high relative to its post-war average. Taxpayers are not responsible for our towering debt—Congress is.

No amount of tax increases can fix our problem. We need to rein in spending!