Wednesday, January 24, 2024

More disinflation, no recession, US king of the world

Both the Fed and most Fed watchers (especially those in the financial press) chronically misunderstand the relationship between economic growth and inflation. Strong growth doesn't cause inflation, and reducing inflation doesn't require a recession. Inflation is the result of an imbalance in the supply and the demand for money. Bringing down inflation requires that the Fed address this imbalance, typically by increasing or reducing interest rates. By the same logic, lower interest rates do not stimulate an economy, just as higher interest rates don't weaken an economy. If interest rates are too low, they will only stimulate inflation; if interest rates are too high, disinflation or deflation will be the result. Economic growth is the result of more people working more efficiently, and that in turn requires savings, investment, and risk-taking. The only way the Fed can influence growth is by implementing monetary policy correctly (thus boosting confidence and investment) or by mismanaging monetary policy (thus destroying confidence and investment).

For most of the past two years the world has fretted that, in order to wrestle inflation down, the Fed would have to raise interest rates by enough to cause a recession. Not surprisingly to those in the know, they have achieved the former without the expense of the latter. For the past several months the world has fretted that the Fed might be slow to reduce interest rates, and that this would jeopardize the economy's prospects.  While it's true that the economy has indeed slowed (see Chart #2 in my last post), there are still no signs of a recession: credit spreads remain quite low, implied volatility is low, corporate earnings continue to impress, the dollar is still king, banks continue to lend, and the stock market continues to rise. All this despite crushing tax and regulatory burdens, mounting geopolitical tensions and a feckless national government. In the fullness of time we'll find out who, if anyone, deserves the credit or the blame for what lies ahead.

The charts that follow provide an update of the critically important M2 story plus an overview of some of the important macro developments in the world economy.

Chart #1

Chart #1 shows the amount of US currency in circulation (it's estimated that a substantial fraction of this is held overseas). I've featured this chart for years, arguing that it is an important gauge of the demand for dollars. People only hold paper currency if they value its utility; if not, unwanted currency is simply returned to banks in exchange for a demand deposit or an interest-bearing security. The chart is plotted with a logarithmic axis, so that a straight line equates to a constant rate of growth. Note the dramatic increase in the demand for currency that began with the onset of the Covid crisis. People everywhere suddenly wanted to stockpile money because of all the uncertainty that was created by lockdowns and the dramatic (and terribly misguided) increase in government control over our lives. But after a year or so, the uncertainty faded and the extra demand for dollars began to decline. Today, we see that the growth of currency is back to the trend it followed from about 1995 through 2019. Demand for dollars, by this measure, has apparently returned to "normal." And importantly, inflation has also returned to something close to normal.

Chart #2

Chart #2 shows the level of the M2 money supply (which includes several forms of money that is readily spendable: currency, checking and savings accounts, CDs, and retail money market funds. Here again we see a surge in the demand for money (yes, M2 is a measure of the money supply, but at times it can tell us a lot about money demand). At its peak in late 2021, there was about $4.8 trillion of "excess" M2, which has since shrunk to $2 trillion.

Chart #3

Chart #3 is an another (and possibly a more intelligent) way of observing the demand for money. It divides M2 by nominal GDP, and that in turn tells us approximately how much of our annual incomes we prefer to hold in the form of readily spendable money. Money demand exploded during Covid, and then collapsed. The explosion in the demand for money meant that most of the $6 trillion in M2 money "printed" by the Fed and the banking system from 2000 through 2021 was happily stored by the public, socked away under mattresses and in bank savings and checking accounts. It wasn't spent, and so it didn't fuel inflation. But as the demand for all that extra money faded (and as the economy gradually normalized), most of the money was spent and that fueled an uncomfortably large rise in the price level (a process hastened by supply-chain shortages). The Fed was slow to understand all this, and was thus slow to raise interest rates. Fortunately, the Fed's higher interest rates eventually offset the decline in the demand for money because they made holding money more attractive. Interest rates are still relatively high and M2 is no longer declining, which is why we are likely to see further disinflation.

Chart #4

Chart #5

While increases in interest rates make holding money more attractive, they also make borrowing money less attractive (it's two sides of the same coin). Chart #4 shows how tighter Fed policy pushed 10-yr Treasury yields (red line) sharply higher, and that in turn pushed mortgage rates (blue line) even higher. Mortgage rates more than doubled in less than one year. Notably, the increase in mortgage rates exceeded the increase in 10-yr Treasury yields, which normally set the tune for mortgage rates. In normal times, the average spread between the 10-yr and 30-yr mortgage rates is about 150-200 bps, whereas today it is almost 250. Between lower 10-yr yields and tighter mortgage spreads, there is room for a substantial further decline in mortgage rates.

Not surprisingly, sharply higher borrowing costs ended up crushing the housing market, as shown in Chart #5. Existing home sales have fallen to 30-yr lows because interest rates are so high at a time when housing prices surged. In other words, the action in the housing market tells us that higher interest rates have had a huge impact on the demand for money. Inflation has come down significantly, and it's only a matter of time before housing becomes more affordable.

Chart #6

Chart #6 compares the level of the S&P 500 to the level of the Vix "fear" index (a measure of the implied volatility incorporated in option prices). Rising fears typically result in lower stock prices, and vice versa. Today the stock market is reasonably comfortable, and prices have attained new highs. 

Chart #7

Chart #7 shows the trade-weighted and inflation-adjusted value of the US dollar vs. two baskets of currencies. By any measure the dollar is historically and impressively strong. That in turn contributes to rising confidence while at the same time attracting investment capital and promoting economic growth. Surely some of the dollar's strength derives from the weakness of other currencies and other economies, and rising geopolitical risk. The US is the world's least scary neighborhood, and there's nothing wrong with that from our perspective. (Though it would be better for everyone if the rest of the world were stronger and healthier.)

Chart #8

Chart #8 compares the value of the dollar (inverted) to the level of industrial commodity prices. A strong dollar typically corresponds to weak commodity prices, and vice versa. Today's strong dollar (as seen in the declining blue line) is exerting downward pressure on commodity prices, and that in turn contributes to a low-inflation outlook.

Chart #9

Chart #9 compares the level of 5-yr real yields on TIPS (a good proxy for how tight monetary policy is) with the 2-yr annualized rate of real GDP growth. Over time these two variables tend to track each other, if only because it takes real economic growth to generate a real return on investment: for example, a zero-growth economy simply cannot afford to pay 3% real yields. Right now we see that real yields are relatively high compared to the economy's recent growth trend, and that implies that Fed policy is still tight and thus quite likely to ease. 

Chart #10

If the US is the world's strongest major economy, China's is surely—especially by comparison to its recent history—the world's weakest. There's no better way to say this than by comparing the two country's stock markets, as we see in Chart #10. Since China first opened up its economy in 1995 (30 years ago!) the Chinese stock market has generated no visible gains. (Note that both y-axes are plotted with a logarithmic axis and constructed to reflect a similar ratio between low and high values.) By contrast, the value of US stocks has risen more than ten-fold. Worse still, Chinese equities have lost more than half their value in just the past two years! This is incontrovertible proof that centrally-planned economies can never be as successful as free-market economies. Governments are incapable of pulling all the right levers at the right time. One can only wonder how much longer Chairman Xi will be the man pulling the levers.  

Chart #11

Chart #11 compares the S&P 500 to the Eurozone Stoxx 600 index. (Note that both axes are constructed in similar fashion to those of Chart #10 above.) Since the lows of 2009, the US stock market has generated a total return 2.6 times greater than that of the European stock market (as calculated by Bloomberg and adjusted for currency valuations). Simply astounding. 

Despite all of the Fed's missteps and the fecklessness of our government and our policies, we still have our King Dollar and we still live in the world's strongest and richest economy. 


Tom said...

Wow - this is a veritable semester class on economics. So much to digest.

While you state that the dollar is still "king", how can it remain strong when public debt is well north of 100% of GDP and entitlement commitments are into the stratosphere?

wkevinw said...

Yes, the free markets in the US have completely out performed the rest of the world. I didn't see how software (mostly) would become the driver of the world economy. Meta, Microsoft, and Netflix are mostly software companies. Tesla, Amazon, Nvidia and Apple are significantly driven by their software even though they sell hardware.

Taiwan Semiconductor might be in this class, as a hardware company, but the list gets shorter. The US is the beneficiary of this "revolution", not Europe, Asia, or any other geography, really.

Americans built markets/products/services that people really never predicted. Who would have predicted something like Meta? Even Microsoft is a crazy concept if you go back before 1980. (for us dinosaurs).

Will it last? I have no idea.

Thanks for the post.

Salmo Trutta said...

It's an understatement that the FED was "slow" to recognize inflation potentials. Means-of-payment money reached an all-time high in its rate-of-change in November 2020.

Economists don't know:

the difference between the supply of money & the supply of loan funds,
the difference between means-of-payment money & liquid assets,
the difference between financial intermediaries & money creating institutions,
doesn't know that interest rates are the price of loan-funds, not the price of money,
that the price of money is represented by the various price (indices) level

Blake Parrish said...

Love your posts and other readings. I re-read your financial posts when the news cycle gets a little annoying.

On the last article posted Jan 24th I think you meant to say the peak in the gap of M2 (chart 2) was late 2021? Rather than late 2001.

All my best

Scott Grannis said...

Thanks Blake for spotting that typo.