Tuesday, January 24, 2023

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.


Andrewinen said...

Dear Scott, thank you for insights. What are you thoughts about offshore dollar system ?

As far as I know it dwarfs money supply/contraction within US borders so maybe it was not monetary inflation in US but just supply shock which increased prices of everything all over the world ?

Salmo Trutta said...


Basel III's LCR, and Sheila Bair's assessment fees on foreign deposits, changed the landscape of FBO regulations. It helped make E-$ borrowing more expensive, less competitive with domestic banks (the exact opposite of the original impetus that made E-$ borrowing less expensive, when E-$ banks were not subject to interest rate ceilings, reserve requirements, or FDIC insurance premiums).

All prudential reserve banking systems have heretofore "come a cropper". The E-$ market is following that historical precedent.

Salmo Trutta said...

re: "that has been supporting a substantial rise in real GDP and a substantial rise in inflation as well"

Remarkable. There are cross-currents in the economy.

Scott Grannis said...

Andrewinen: I think a similar dynamic has played out in many developed countries: At first, big increases in money supply accommodated big increases in money demand. Then money demand started falling and spending began picking up but both collided with supply shortages which drove prices higher. Now we are in the correction phase, with higher interest rates offsetting the weakness in money demand and thus mitigating further price increases.

Duncan said...

I have seen three articles today including Reuters stating that the long-ignored indicator M2 is in decline and economists are waking up and starting to note M2 as a predictor of inflation when rising, including Bullard at the Fed. Good for us Scott has been talking about this for at least two years!