Saturday, October 28, 2023

Growth and inflation update: not much to worry about

The big news this week—though widely anticipated—was the 4.9% annualized growth of the economy in the third quarter. Analysts still infected by Phillips Curve thinking worried that a strong economy would encourage the Fed to keep rates "higher for longer," thus posing the risk of a recession next year. (Note: economic growth does not cause inflation. In fact, over the past year the economy has continually beat growth expectations, all the while inflation has been declining rather significantly.) By week's end, worries about Middle East tensions trumped growth fears, and inflation data showed that disinflation, not inflation, remains the order of the day. Interest rates backed off their highs, and equities traded lower. Expect Phillip Curve nightmares to continue to haunt the market this coming week. As for Middle East tensions, well, that merits concern but I don't know of any obvious solution to that.

Chart #1

While 4.9% growth in one quarter certainly stands out as a big number, it's worth noting that it's an annualized number. In fact, the economy reportedly grew only 1.2% in the third quarter. And as Chart #1 shows, the path of real GDP (blue line) experienced only a small wiggle to the upside with this latest number, and it will probably experience a much smaller wiggle next quarter. The big story with GDP is that the economy has been growing by more or less 2.2% since mid-2009. That's a lot slower than the 3.1% trend which prevailed from 1965 through 2007. Today, the U.S. economy is unfortunately not in danger of growing too fast. It is just muddling along, fighting the headwinds of very high tax and regulatory burdens aggravated by excessive government spending on transfer payments and "green" energy boondoggles (green energy needs subsidies to compete since it's woefully inefficient).

 Chart #2

Chart #2 shows the year over year change in the GDP deflator, which is the broadest measure of inflation we have. By this measure, inflation has fallen from a high of 7.7% to now 3.2%. 

Chart #3

Chart #3 shows the 6-mo. annualized rate of change of the Personal Expenditures Consumption Deflator and its core (ex-food and energy) version (note: the PCE deflator is a better measure of inflation than the CPI because the weights of its components change dynamically as consumer habits change). Over the past six months both of these measures show inflation rising at a 2.8 - 3.2% annual rate, only about 1 percentage point faster than the upper end of Fed's target. 

Chart #4

Chart #4 breaks down the Personal Consumption Deflator into its 3 main categories. Note the impressive decline in durable goods prices which began in 1995, the year China first opened its economy to world trade. Most of the increase in inflation in recent decades comes from the service sector, which in turn reflects mostly wages. The huge increase in wages alongside a significant decline in durable goods prices means that an hour's worth of work today buys more than 3 times as much in the way of durable goods as it did in 1995. We've never before seen such an increase in purchasing power; prior to 1995, durable goods prices never declined on a multi-year basis.

Chart #5

Chart #5 shows real and nominal yields on 5-yr Treasuries and the difference between the two (green line), which is the market's expectation for what CPI inflation will average over the next 5 years. The rise in yields over the past 18 months has been driven almost exclusively by the rise in real interest rates. Real rates, in turn, are the best measure of how tight monetary policy is. Thus, tight money (as measured by a 340 bps rise in real yields) has brought inflation expectations down to about 2.3%, which is almost exactly the upper bound of the Fed's target for PCE inflation (2%), because the CPI tends to exceed the PCE deflator by about 30-40 bps per year.

Chart #6

Chart # 6 compares the level of real yields on 5-yr TIPS to the 2-yr annualized growth of GDP (which I use because it smooths out the random quarterly variations in actual GDP growth, and it likely mimics the public's perception of what current GDP growth is). Real yields tend to track the strength or weakness of the economy; high real yields prevailed in the late 1990s when the economy was exceptionally strong (growth rates of 4-5%), and real yields have been low during most of the past decade as the economy has averaged 2% annual growth. With the exception of the past 18 months, of course, when real yields have surged. If the economy remains on a 2.2% growth path, it wouldn't be unreasonable to expect that real yields will decline significantly from today's 2.4% levels. That would likely coincide with a relaxation of the Fed's monetary stance, and that, in turn, would provide welcome relief to the market.

Wednesday, October 25, 2023

M2 update: continued disinflation

With this post I provide continued coverage of the all-important M2 money variable that almost no one, including the Fed, has bothered to pay attention to for the past several years. Click here to see my first post (October '20) highlighting the extraordinary growth of M2 and why it wasn't inflationary. Click here to see my first warning (March '21) that rapid M2 growth threatened a significant increase in inflation. Click here to see my first prediction (May '22) that slowing M2 growth presaged declining inflation. 

I'm happy to report that M2 continues to decline, thus ensuring continued disinflation. It's still early to worry about deflation, but it could happen if the Fed waits too long to start cutting interest rates.

Chart #1

Chart #1 shows the level of M2 compared to its 6% trend rate of growth which began in 1995. (Note the use of a semi-log scale for the y-axis, which displays a constant rate of growth as a straight line.) At the peak of the M2 "bulge" in December '21, M2 exceeded its trend by about $4.8 trillion. The "gap" has now shrunk by more than half, and currently stands at about $2.2 trillion. The gap has shrunk due to 1) soaring interest rates, which have slowed loan growth, and 2) declining demand for money, which has fueled spending and higher prices. 

Chart #2

Chart #2 compares the growth rate of M2 with the size of the federal budget deficit. Here it becomes obvious that the $6 trillion surge in deficit-financed spending in 2020 and 2021 was almost entirely monetized, thus boosting M2 by $6 trillion. The good news is that despite continued deficit spending since mid-2022, virtually none of it has been monetized. Thus, ongoing deficits no longer pose a risk of higher inflation. 

Chart #3

Chart #3 compares the growth of M2 with the rate of consumer price inflation. I've shifted the CPI line one year to the left, to show that it took about one year for the huge increase in M2 to find its way into the inflation statistics. The chart further suggests that since M2 growth has been declining for well over one year, CPI inflation is likely to continue falling for at least the next 3-6 months and could potentially reach zero. In my previous post I argued that inflation has effectively fallen to the Fed's target zone already.

Chart #4

Chart #4 shows the level of currency in circulation, which represents about 10% of M2. This is an important statistic to follow because it helps to understand what I call "money demand." Nobody holds large amounts of cash unless they really want to. Suppose, for example, that you discover a suitcase full of bundles of $100 bills in your basement. Your first instinct would be to take that cash to your bank and deposit it to your checking or savings account in order to earn interest. The bank, in turn, would receive that cash and most likely send it off to the Fed, where it would be effectively removed from circulation. In places like Argentina, however, where holding dollar bills is essentially the only way that people can safeguard their cash holdings, millions of people happily stuff bundles of $100 bills under their mattress. (It's estimated that some $250 billion in US currency is held by Argentines.) 

This chart confirms that money demand surged in the wake of the Covid shutdowns and then began to taper off as the economy slowly began to return to normal over the course of 2021. Strong money demand neutralized the surge in M2 at first—we know that because inflation did not rise until well after M2 ballooned. But then money demand weakened, causing money to be released into the economy, where it supported a growing economy and fueled higher prices. 

Currently, I estimate that there is only about $50 billion of "excess" currency in circulation, which implies that money demand has just about returned to normal. And that, in turn, suggests that the monetary fuel for higher inflation has just about dried up.

Chart #5

Chart #5 is another way of looking at "money demand" on an economy-wide scale. It's simply the ratio of M2 to nominal GDP, and as such, it's a proxy for how much of our annual incomes we collectively prefer to hold in currency, bank checking and savings accounts, and retail money market funds. Money demand surged with the Covid shutdowns, rising fears, and great uncertainty, then collapsed as the economy returned to normal and the price level rose. According to this chart (and Chart #1) there is still an excess of M2, but its inflationary potential has been largely neutralized by the Fed's aggressive rate hikes. (Higher interest rates encourage people to hold higher money balances than they normally would, instead of spending them down.) 

Friday, October 20, 2023

Argentina votes as the peso plunges

I've been an observer of the Argentine economy ever since I first went there in 1970 to visit my soon-to-become wife. So I am compelled to make this brief post as Argentina's currency passes a key marker: today, Argentines must now come up with 1000 pesos to buy just one dollar. Actually, if Argentina had never taken multiple zeros off its currency several times since 1916, when the exchange rate was 2 pesos per dollar, today it would take 10,000,000,000,000,000 (ten quadrillion) of those original pesos to buy a dollar!

The spark behind the latest peso plunge is Sunday's presidential election. The front-runner, Javier Milei, promises to ditch the peso and dollarize the economy. Which, in my opinion, is the only sensible thing to do, though it might prove tricky to implement. The Argentine government has been resorting to the printing presses to finance its profligate spending for far too long. People know that every day you hold a 2,000 peso note (the largest note in circulation!) in your pocket you are losing money at the rate of 150-200% per year—i.e., the current rate of inflaton. So the demand for pesos has plunged and the demand for dollars has soared. No wonder Argentines are demanding radical change—this has gone on for far too long.

The lesson in this for the U.S. is that our government seems to have abandoned any concern over deficit spending. The budget deficit for the just-finished fiscal year was about $1.700,000,000,000, which is over 6% of GDP. It only exceeded that level during WW II, the 2008-09 Great Recession and its aftermath, and the 2020-22 Covid shutdowns. Today it's sky-high despite the fact that the economy is relatively healthy. Federal debt is now about 94% of GDP, and annual interest payments on that debt are about $1 trillion and rising. We were flirting with Argentine-style inflation a few years ago, when the M2 money supply increased by $6 trillion (40%) in less than two years, thanks to $6 trillion of Covid-related deficit spending.

Chart #1

As Chart #1 shows, since 2007 the peso has lost 99.7% of its value vis a vis the dollar, and the losses are accelerating. Something is going to have to change, and quickly, or the economy will grind to a halt for lack of money. Let's hope our own Congress can get its act together as well.

Thursday, October 12, 2023

CPI ex shelter is 2.0%

On a year over year basis, the CPI is up 3.7%. Excluding shelter costs, which we know are artificially inflated by BLS methodology, the CPI is up only 2.0%. It is not unreasonable to think that the Fed has successfully arrested the inflation that was caused by $6 trillion of federal deficit spending in 2020 and 2021. Mission accomplished. No more rate hikes are needed.

Chart #1

Chart #1 compares the year over year change in the CPI index (blue line) and the CPI index less shelter costs (red). The CPI including all prices rose 3.7% in the past 12 months, but excluding just one category—shelter costs, which are heavily influenced by housing prices 18 months prior—the CPI was up only 2.0%. 

Chart #2

Chart #2 shows how BLS methodology effectively uses changes in housing prices 18 months prior (blue line) to drive the Owner's Equivalent Rent component of the CPI, which makes up about one-third of the CPI. Housing prices and rents stopped rising over a year ago, but the BLS is assuming that shelter costs are still rising at a 7% annual rate, thus artificially boosting the overall CPI. For the next six to nine months, the BLS-calculated increase in shelter costs will be dropping significantly, and that will meaningfully reduce the shelter contribution to the CPI. Meanwhile, the CPI has received a boost from rising gasoline prices in August and September; and a lot of that boost will reverse in coming months, since nationwide gasoline prices have fallen in the past several weeks. In short, expect measured inflation to remain low for the foreseeable future. Low enough to keep the Fed from raising short-term interests rates further than they already have.