Tuesday, April 25, 2023

M2 update: a return to normal by year end

Today the Fed released the M2 statistics for the month of March '23, and they were very encouraging. The decline in M2 which began about a year ago is accelerating, with the result that M2 has fallen by almost $900 billion (-4.1%) since its peak. Considering the ongoing growth in the economy and incomes, the ratio of M2 to GDP is now on track to return to pre-Covid levels by the end of this year. This is occurring despite a significant increase in federal deficit spending in the past 9 months (i.e., deficits are no longer being monetized). In short, the monetary inflation wave that flooded the US economy in recent years has receded significantly; as a result, inflation should return to some semblance of normal by the end of this year.

Chart #1

Chart #1 shows the growth of the M2 money supply, which mainly consists of currency in circulation, bank savings and deposit accounts, and retail money market funds. From 1995 through early 2020, M2 growth averaged about 6% per year. It then surged by some $6 trillion as the government began showering consumers with Covid emergency money, most of which ended up in bank savings and deposit accounts. Once the public began spending all this extra money, in early 2021, inflation began to rise.  

M2 growth started decelerating early last year and has since turned decidedly negative. As the chart suggests, the "gap" between actual M2 and where it would likely have been under normal conditions has narrowed by over 40%. At the current rate of M2 decline, the gap will be closed around January or February of next year.   

Chart #2

Chart #2 compares the growth of M2 to the size of the federal budget deficit. This is strong evidence that the outsized growth of M2 which ultimately fueled the big increase in inflation in recent years was the direct result of monetized federal deficit spending. It's VERY reassuring to see that although the federal deficit has been rising for the past 9 months, M2 growth has continued to decline. 

Conclusion #1: federal deficits are no longer being monetized. Thus, the monetary source of rising inflation has dried up. 

Chart #4

Chart #4 shows that there is about a one-year lag between growth in the money supply and the rate of inflation. (The CPI line has been shifted one year to the left so as to make this easier to appreciate.) The big acceleration in M2 growth which began in March '20 was followed by a big acceleration in inflation which began about a year later. Now the tables have turned: The sharp deceleration in M2 growth which began about two years ago was followed about one year later by a deceleration of the CPI. This strongly suggests that we are likely to see a further—and significant—decline in inflation over the course of the next 6-9 months.

Conclusion #2: there is no longer any need for the Fed to tighten monetary policy any further. Excess money dumped into the economy during the Covid crisis is being absorbed, and federal deficits are no longer being monetized. Without monetary fuel, and given that interest rates have been hiked significantly, the odds of a return to "normal" levels of inflation have improved dramatically. Instead of hiking rates next month, the Fed could, and probably should, lower rates, especially in view of increasing signs of economic weakness (e.g., disappointing corporate profits, lower confidence, a housing market on the skids).

Chart #5

Chart #5 is one I've been following for decades. It's very important because it sheds light on the all-important issue of the demand for money. As Milton Friedman taught us, inflation happens when the supply of money exceeds the demand for money. M2 is the best measure of the supply of money, but we lack any direct measure of the demand for money. As I explained in a long post early last year, Chart #5 is a good approximation for the demand for money. 

The initial surge in deficit spending (Q1, Q2, and Q3 of 2020) was effectively neutralized by an equivalent surge in money demand, with the result that inflation remained low throughout 2020 despite an enormous increase in M2. But then money demand weakened even as M2 continued to grow, and that imbalance fueled the rise in inflation that began in early 2021. The recent plunge in money demand (which began in earnest about a year ago) was offset somewhat by flat to falling growth in M2, with the result that inflation began cooling. Sharply higher interest rates, courtesy of the Fed (belatedly) also helped offset the inflationary potential of M2 by increasing the attractiveness of holding money and creating disincentives for borrowing—thus contributing to a slowing in the money supply.

At the current rate of decline in money demand, it should return to pre-Covid levels by the end of this year—at about the same time as the M2 money supply returns to its pre-Covid long-term trend. As Milton Friedman might observe, money supply and money demand are coming back into balance, and that means inflation is yesterday's news.


Salmo Trutta said...

It seems incredulous to me that the pundits are clamoring about a deceleration in the money stock. No money stock figure standing alone is an adequate signpost for monetary policy. And Barnett’s Divisia aggregates and Rothbard-Salerno’s TMS figures show poor correlations for N-gDp. Hunt’s ODL is not a superior metric. M2 is mud pie.

Banks don't lend deposits. Only deposit holders/owners can spend or invest their funds. The banks can't use these deposits. Banks create deposits when they lend/invest. And the volume of money (stock) is irrelevant unless it is turning over (flow). Thus, one should use means-of-payment money in their analysis.

Link: George Garvey:
Deposit Velocity and Its Significance (stlouisfed.org)

“Obviously, velocity of total deposits, including time deposits, is considerably lower than that computed for demand deposits alone. The precise difference between the two sets of ratios would depend on the relative share of time deposits in the total as well as on the respective turnover rates of the two types of deposits.”

The rate-of-change in short-term money flows, the proxy for real output increased in March.

Salmo Trutta said...

There are countervailing forces at work. Demand for money is falling (velocity rising).

But M2 does get the magnitude and duration of inflation better than most metrics.

Salmo Trutta said...

What's interesting is that Shadow stats reports that “Basic M1” (Currency plus Checking) jumped to a new 53-year high of 35.0% of the aggregate Money Supply M2."

That implies that the velocity of money is increasing.

Scott Grannis said...

Money demand is plunging: another way of saying that money velocity is surging.

JG said...

Energy costs could blow these projections out.

Salmo Trutta said...

The distributed lag effect of long-term money flows, the volume and velocity of money, the 24-month roc, the proxy for inflation, is still historically high. And its roc trajectory comes down to normal or historically proportional levels by the 4th qtr. this year.

But proportionality is affected by the transaction's velocity of money, debits to deposit accounts, which Greenspan discontinued in September 1996 (the G.6 release). Nowadays, I need a disclaimer.

The roc in the proxy for real output, R-gDp, is positive for the 1st qtr., but could become negative in the 2nd qtr. (if money growth stalls). TBD

WorthF said...

Scott - you commented that "federal deficits are no longer being monetized". And yet, Congress and the White House have passed bills over the past 9 months to increase spending. My argument is that the Federal Spending is growing BUT with the debt ceiling held-tight and the Treasury using "extraordinary means" that once the debt ceiling is lifted - the Federal spending WILL BE monetized again. I've been watching M2+TAG and it's not as dramatic of a decrease and once the Federal debt limit is raised, M2+TAG will rise again and show up in the August M2+TAG numbers?? Honest question, where am I off? Or is this too small of potatoes to move the needle?

Scott Grannis said...

What exactly is M2+TAG? I've never heard of that before.

WorthF said...

Sorry Scott - TGA "Treasury, General Account" It used to be very small and since 2020 it's been as high as $750B, i believe and it's been shrinking as well in the last few months, I believe mostly because of the "extraordinary measures", but it jumped back up a bit two weeks ago to $265B because of the tax-payments (mine included) and then yesterday it came in at $296B.

Scott Grannis said...

$250B or $750B is not enough to move the needle in my view. The monetization we saw in 2020 and 2021 was on the order of $6 trillion. And anyway, we still do not know exactly how $6trillion was monetized or by whom. But for the past year or so there has been zero monetization of the ongoing federal deficit which is on track to reach almost $2 trillion in the current fiscal year.

Mark said...

Scott, as I write this, market pressure on midsize banks is not diminishing, even after First Republic buyout. Your arguments for the Fed loosening now are very persuasive … but the Fed still seems quite unsure whether inflation is “defeated” yet or not. What do you think of the following approach that might help from various angles: Start lowering Fed fund rates very soon, but simultaneously increase quantitative tightening of the longer term treasuries that the Fed has on their balance sheet. That would help the banks (reduce inverted yield curve), but still perhaps be a reasonable trade off (for the Fed) of loosening vs tightening.

Scott Grannis said...

To judge from the current level of interest rates, the market seems convinced the Fed will raise rates 25 bps tomorrow. But the market is also convinced that the Fed will then need to cut rates several times before the end of the year. This is madness.

With the bank crisis again in full bloom and stocks down today, another tightening tomorrow would seem nothing short of madness. The bond market is telling the Fed that inflation is under control already: 5-yr inflation expectations have fallen to a mere 2.2% today. The dollar is trading at reasonable levels; not too strong, not too weak. Commodity prices are soft; oil is down 40% from the level that prevailed last June.

Most importantly, the banking crisis is the direct result of the Fed's tightening actions over the past year or so. Sharply higher bond yields have severely impacted the bond portfolios of all the nation's banks. So another tightening at this point would only add fuel to the fire.

Simply put, the Fed needs to cut rates. Now. That would relieve all the negative pressures that have accumulated.

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