Thursday, January 26, 2023

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


Roy said...

So we know what the Fed should do, but what are they going to do? It's 0.25% or 0.5%, there's no way they are going to pause now.

Unknown said...


In your view,besides keeping interest rates at their current level through the year, what is the right rate of growth for M2?

Anecdotally, I am seeing banks, particularly smaller ones, aggressively trying to draw in deposits with much higher rats (3% to 4%) -

Look forward to your thoughts!


Downtown Adam Brown said...

@Roy, I think the market is slightly favoring a 0.5% increase (something like 0.4% expected, vs. .375% which would be a coinflip between the two).

@Tom, I believe in earlier posts Grannis has shown M2 growing on a "normal" 6% trendline.

cyclingscholar said...

While Scott suggests the FED should leave interest rates at current levels and wait a few sessions to see if the higher rates bite the economy and price levels a bit, I lean toward having one additional increase of 0.25% this February. The FED needs to demonstrate its commitment to price stability, and I'd rather not have them go wobbly while prices are still climbing at an uncomfortable rate. The stock market and the economy have shown their resilience in the face of higher rates: in fact, cyclical stocks like DOW (the former Dow Chemical) have performed quite well recently, even in the face of lower earnings.

Roy said...

Adam Brown, the market is clearly pricing in 25bps and that indeed the Fed will pause, ignoring what the Fed said previously.

Scott Grannis said...

The 6-mo annualized increase in the Core PCE deflator (the Fed's preferred measure of inflation) has fallen to 3.7%, and the 3-mo. annualized increase in the same measure is now down to 2.9%. Every measure of inflation has fallen significantly over the past 6 months. Higher interest rates are working. The economy is in no danger of being "too strong" (as inflation worriers worry), and there are uncomfortable signs of slowing in housing, industrial production, and capital goods orders. Today Larry Summers urged the Fed to avoid further mention of rate hikes "given the indications of softness that we have seen from a number of quarters."

Personally, I think the Fed would be fully justified in either raising rates by 25 bps or holding steady, and in any case, I expect they will say that they will be watching the numbers for indications of whether or not they should hike further, which translates into an indefinite pause.

I can't discount the possibility that they will hike by only a quarter point, since that would be the path of least resistance for the time being. But I would be shocked if they hike by a half point.

As for M2, I would like to see it decline further at the current pace for another year, then resume its 6% trend growth rate.

Downtown Adam Brown said...

@Roy, you're absolutely right. I was looking at a chart forecasting rates over the next 12 months and saw rate expectations 0.4 higher before flatlining. But that 0.4 higher was 2 increases from now, not the next one. I stand corrected and thank you.

Roy said...

There are recent signs that housing might have bottomed in December, at least for now.

I'm just playing devil's advocate here, but if the economy is growing, employment is low, markets going up, and oil coming down, the Fed has less political resistance to raise rates. My bet is 25bps (with let's say 10% for 50bps) with very hawkish guidance. The market of course might be happy to ignore the guidance.

And then there's China. How does the Fed see China opening? At a minimum, it's a combination of uncertainty and the possibility of added inflation.

Roy said...

And how about Argentina and Brazil's ""common currency"". Truly unbelievable how they came up with this nonsense.

Ai said...
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Ai said...

Since stock market UP does not equal inflation.

Why would interest rates DOWN equal inflation?

Richard H. said...

Can anyone please tell me if the following statements are true or false:

The Fed cannot buy Treasury debt directly.
Banks can buy Treasury debt.
Banks can sell Treasury debt to the Fed
Banks get Reserves as payment from the Fed
Banks can use these Reserves to buy more Treasury debt (with or without leverage).
This can go on as long as the Fed wants it to.

If this all is true, how is this not printing money?
I apprediate any comments.

Salmo Trutta said...

The economy is being run in reverse. O/N RRP volumes are > 2 trillion. The FED can't lower policy rates without unleashing this tsunami. Stagflation and an inverted yield curve will become permanent features on the landscape.

Salmo Trutta said...

re: "This can go on as long as the Fed wants it to."

That's false.

And outside money, interbank demand deposits, are not the same as inside money. So, whether printing money is involved depends on the counterparty in the transaction, a bank or its reserves, or a nonbank (money + reserves).

Scott Grannis said...

Answers to Richard H
The Fed cannot buy Treasury debt directly. -true
Banks can buy Treasury debt. -true
Banks can sell Treasury debt to the Fed -true
Banks get Reserves as payment from the Fed -true
Banks can use these Reserves to buy more Treasury debt (with or without leverage) -false

Reserves are not money. They can't be used to buy anything, except that they can be exchanged for Treasury debt with the Fed (thus reversing the initial transaction (when the Fed buys Treasuries from banks and pays for them with reserves).

Richard H. said...

Thank you Salmo and Scott.
Ok,perhaps I left out one step?:
- Banks use Reserves to create inside money (out of thin air) to purchase more Treasuries to then sell to the Fed.
Is this true?

Scott Grannis said...


Richard H. said...

Ok, thank you. Then where do banks get the $ to buy all the Treasuries to sell to the Fed? I thought the whole thing we have been told the last several years is that, with the help of Double Entry Bookeeping, the banks can create money (liability) when they buy (or loan) a security (asset)? Who they turn around and sell it to, in this case the Fed (for Reserves instead of Treasuries), does not matter.
Thank you again!

Scott Grannis said...

Banks can create money by making new loans (for cars, mortgages, etc). They post the loan as an asset and deposit money to the borrower's account as a liability. Before 2008 they were somewhat constrained in this ability since they needed to have bank reserves to collateralize their deposits (about one dollar of reserves for 10 dollars of deposits). Before 2008, reserves paid no interest, so they were a "dead" (non-earning) asset, and thus they always held the minimum amount of reserves. Now reserves do pay money and they are plentiful, so banks theoretically have an almost unlimited ability to make new loans. Reserves are now an attractive asset (default free and interest bearing).

Banks can use deposit inflows to purchase Treasuries which they can then sell to the Fed, but only if the Fed wants to increase the supply of bank reserves by expanding its balance sheet. Banks can also use deposit inflows to buy other assets (loans, corporate debt, mortgages).

Benjamin Cole said...

Paul Krugman just tweeted a chart. CPI inflation annual rate, last six months...under 2%.

Richard H. said...

Thank you Scott.
Ok, I understand these things - I think. But (of course) …, if the banks cannot use Reserves as collateral to buy more Treasuries, where do/did the banks get the TRILLIONS of dollars to buy Treasuries to sell to the Fed? Deposit inflows from private loans do not seem to be enough.
(.. sorry .. I do appreciate it)

Scott Grannis said...

Richard: I have yet to see anyone come up with a complete forensic analysis of where the money came from and where it went. Somewhere along the line trillions of dollars of money were "created" and held in bank deposit and savings accounts. Bank reserves were about $1.5 trillion before Covid, and they are now $3 trillion. M2 grew from $15.5 T pre Covid to now $21.2T. The Fed's balance sheet grew by about $5 T. The exact numbers and where they came from are not as important as is the public's demand/willingness to hold lots of cash on their balance sheets. The latter is what I have been focusing on.

Scott Grannis said...

Benjamin: Paul Krugman is a bit late to the party. I made that point (CPI now under 2%) in Chart #1 of my January 12th post.

Benjamin Cole said...


My apols. At my age, I sometimes forget what I read yesterday...or this morning.

Don't mind me and keep writing!

Richard H. said...

Interesting. I assume it is also unknown where the money came from (for the banks to buy treasuries to sell to the Fed) after the GFC (2008) ...
Thank you Scott.

Carl said...

Pick any beginning and end date of M2 growth, look at total loan growth, QE to non-bank participants (about all QE) and commercial banks' net holdings of government debt and you get a very close approximation (there are other minor factors).
Simply go to Fed data. It's not that complicated.

Richard H. said...

Thank you Carl. If I go to Fed data (St. Louis - how did St. Louis become the center for it?) and search for loan info I get this with many options:
Do you know, off hand, where to find QE to non-bank?
Thank you.

RJ said...
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RJ said...

Chart number 9 says it all. Do the feds look at this stuff or are they all still drinking the Keynesian Kool-aid? Thanks always for your insight, Scott.

Downtown Adam Brown said...

@Richard H.

I was actually at the St. Louis Fed last Friday and asked that question, about how they became the center for the data. The answer is that while all of the Fed locations work together and toward a common goal, they are all run independently and compete for resources and recognition.

The FRED system of data resides in St. Louis because the St. Louis Federal Reserve created it. Simple as that.

Richard H. said...

Downtown Adam: thank you. Interesting how things happen ..