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.) 


R Paul Drake said...

A technical question: Are sweep accounts at brokerages counted with "retail money market funds" in M2? It seems to me that the line between investments and cash is becoming increasingly blurry.

Adam said...

Thanks for that great recap.
Your thoughts on holding equities vs bonds.
( 5% yield on 10y bonds vs 2% GDP plus 2% DY on equities).?

pemdas1 said...


Your posts correctly point out that the lag in housing data causes reported inflation numbers to be high.

On the other hand, health insurance data has a similar problem, and is causing inflation to be understated. The health insurance input to inflation data, because it is difficult to figure, is calculated only one a year and then spread out over the following year. Laughably, reported inflation data has had health costs DECREASING for the past year, reducing reported inflation.

Wall Street Journal reports health costs have actually risen 14% over the year, now $24,000 health insurance for a family of four. When the health cost input to inflation is recalculated in the near future (I believe here in November) it will flip health costs to a positive number and add to inflation over the nest year.

Healthcare weighting in the inflation number is not as big a housing, but it will be a sticky, persistent, and significant upside to reported inflation.

Higher for longer, as the Fed says. Until something breaks...

Salmo Trutta said...

Our money and banking system has been grossly mismanaged. One root cause has been the inability of the Fed, the Congress, and academia, to recognize the crucial importance of the difference between money creating institutions and financial intermediaries. This misconception has been aided and abetted by the universal opinion held by commercial bankers that they loan out the savings of the public.

Large CDs should be included in M2. MMMFs should not be included (there's a difference between theory and practice).

Our means-of-payment money is the “yardstick” by which the liquidity of all other assets is measured.

Salmo Trutta said...

“Real gross domestic product (GDP) increased at an annual rate of 4.9 percent in the third quarter of 2023 (table 1), according to the “advance” estimate released by the Bureau of Economic Analysis”

Our means-of-payment money supply has flatlined. But the velocity of circulation has increased.

Dr. Philip George:

(1) “The velocity of money is a function of interest rates” and

(2) “Changes in velocity have nothing to do with the speed at which money moves from hand to hand but are entirely the result of movements between demand deposits and other kinds of deposits.”

Debits to deposit accounts have accelerated

Beau Duncan said...

why were there two waves of inflation in the 1970's ? each one coincided with Opec price increases following the devaluation of the dollar when we went off the gold standard , thereby underpricing oil in dollars , does that explain it?

Vandy said...

@Beau, the OPEC embargo in retaliation of U.S. supporting Israel during Yom Kippur War was what quadrupled gas prices in US during the 70’s.

Adam said...

Any ideas about equties valuations over next decade? Should standard measures like P/E stay on last decade average or go lower?

Roy said...

Thank you, Scott.

Regarding Chat no. 1. It looks like it has been plateauing for the past half a year or so, rather then continuing its downward trend? Isn't this concerning re. inflation?

Thenagain said...

^Chart 1 is almost a perfect depiction of the money experiment described by Friedman. You now have an inflated M2 with, everything else held constant, would continue to rise at the so called 6% trend growth.
This is why non-linear changes are so interesting.

Stardust Capital said...

I'm buying Jan 2025 TLT leaps call spreads out of the money.
Huge payout if the rates drop by then.
Either fed lowers cause the inflation drops, either we hit a recession cause they're too tight
It's almost a win-win trade.