Tuesday, June 4, 2024

Tight money hasn't hurt corporate profits

The market tries, but just can't shake its Phillips Curve instincts, which is why any news that is considered to increase the likelihood of interest rates being "higher for longer" is deemed bad for the economy and bad for stocks, and vice versa. It's not surprising that this is so, since decades of experience have taught the market that recessions reliably follow periods of tight monetary policy. ("Tight" being defined, traditionally, as high and rising real interest rates, and a flat to inverted yield curve, and a strong currency. I've maintained for many years, however, that a better definition of tight money would include high and rising credit spreads.)

What the market is missing is that the Fed in 2009 adopted an abundant reserve regime that changed everything. Higher interest rates since then have not equated to bad news for the economy because abundant reserves mean abundant liquidity, and that in turn is what keeps the economy on an even keel and credit spreads low. Meanwhile, falling inflation restores confidence to the economy, and that boosts investment and productivity. That's certainly the case today: credit spreads are quite low—which in turn suggests that markets are functioning well and the outlook for the economy's health is decent. Even though monetary policy is almost certainly tight.

Chart #1

Currency in circulation (Chart #1) grew at a fairly steady pace of 6.6% per year from 2010 through 2019. It then exploded upward in the wake of the massive Covid stimulus spending. Over the past few years the pace of currency growth has slowed dramatically: currency in circulation has increased by only 1.3% over the past year. 

If the trend line in Chart #1 represents "normal," then this chart suggests that money supply (in the form of currency) now matches money demand and monetary conditions are supportive of a low inflation outlook. (As I've argued before, the supply of currency is always equal to the demand for currency, since unwanted currency is simply returned to banks in exchange for deposits.)

Chart #2

The M2 measure of money supply grew at a fairly steady pace of 6% per year from 1995 through 2019, as shown in Chart #2. It then exploded upwards by about $6 trillion, which was the result of the monetization of $6 trillion in COVID "stimulus" checks. For the past two years, M2 growth has been flat to negative. As the chart suggests, it's only marginally higher today than it would have been in the absence of COVID spending. By this measure, monetary conditions have gone from extremely easy to reasonably tight. Tight, because the money supply has shrunk, inflation has fallen, real yields are relatively high, and interest-sensitive sectors of the economy (such as housing) are suffering.

Chart #3

As I define it, "money demand" is best expressed as the ratio of M2 to nominal GDP, which can be thought of as the amount of cash that the average person wants to hold compared to his or her annual income. Chart #3 suggests that, as is the case in the previous two charts, monetary conditions have almost returned to normal. Money demand surged during the Covid crisis, only to reverse once the economy got back on its feet. Money demand now is almost back to pre-Covid levels. There is no longer a huge surplus of unwanted money to fuel rising prices.  

Chart #4

Chart #4 shows the value of the dollar vis a vis a relatively small basket of major currencies and a large basket. Most importantly, the chart adjusts for inflation differentials, which means that it is a good indicator of the purchasing power of the dollar in different countries. By any measure, the dollar today is quite strong from an historical perspective. This is way tight money works: attractive interest rates plus confidence in the Fed's ability to constrain inflation create extra demand for dollars relative to other currencies. 

Chart #5

Chart #5 shows the rate of inflation according to the total and core versions of the Personal Consumption Deflator. Clearly, whatever the Fed has done in the past two years ago has resulted in a significant decline in inflation. 

Chart #6

Chart #6 shows the three major components of the Personal Consumption Deflator. Here we see that prices of durable goods have actually declined in the past year, while the prices of non-durable goods have increased only marginally. The only significant source of inflation is in the services area, which is dominated by wages. It's not unusual for wages to lag price increases in other sectors. Wage increases are thus likely to moderate going forward, and this will bring headline inflation back down to the Fed's target.

Chart #7

Chart #7 shows that corporate credit spreads are very low from an historical perspective. This is the bond market's way of saying that investors are quite confident in the outlook for corporate profits. And, by extension, confident in the future health of the economy. 

Chart #8

I have been updating and publishing Chart #8 for at least the past decade. To this day it amazes me that it has not received more attention. The 3.1% trend line (green) represents the growth path that the economy followed from 1965 through 2007. The 2.2% trend line (red) represents the growth path that largely has prevailed since mid-2009. If the economy had regained the 3.1% growth path after the 2008-2009 Great Recession, it would be fully 25% bigger in real terms today! (What a difference 1% less growth per year can make!) What explains today's slower growth should be the issue that is front and center of the national debate. My short explanation is that the economy has lost its dynamism due to 1) excessive government spending, 2) increased tax and regulatory burdens, and 3) rising transfer payments.

Chart #9

Chart #10

Charts #9 and #10 compare the level of corporate profits to the nominal size of the US economy. By either measure, profits are exceptionally strong. If this is the price of "tight money" then let's have more of it! (Note: I have excluded profits and losses generated by the Federal Reserve's abundant reserve regime from overall corporate profits.)

Chart #11

A traditional measure of equity valuation on a macro level compares the price of stocks to the trailing 12-month sum of after-tax corporate profits (the price-earnings ratio, or PE). Chart #11 does the same, but it uses the level of after-tax corporate profits as calculated by the National Income and Products Accounts over the past quarter. This is a more timely and more consistently-calculated measure of profits than the traditional PE ratio. (I credit Art Laffer for this, an approach he has been using for over 40 years.) By this measure stocks are relatively expensive, but not extremely so. 

Chart #12

Borrowing from Art Laffer again, Chart #11 compares the theoretical level of corporate profits (calculated as the capitalized value of NIPA profits—profits divided by the 10-yr Treasury yield) to the market value of stocks as proxied by the S&P 500. Note that, according to Chart #12, stocks were hugely "overvalued" in 2000, and they were also very overvalued at that time according to Chart #11. Today, however, stocks appear to be appropriately valued, since their actual and nominal valuations are roughly equal. 10-yr Treasury yields both drive and explain the differences between these two measures of equity valuation.

This in turn implies that lower interest rates (which should follow the decline in inflation) will increase the appeal of equities as an asset class. This in a nutshell is the "Fed put" that I mentioned in my previous post. Tight money hasn't hurt the economy at all.


EHR said...

"My short explanation is that the economy has lost its dynamism due to 1) excessive government spending, 2) increased tax and regulatory burdens, and 3) rising transfer payments."

As a non-economist, I see a psychological reason possibly for this and perhaps contributing to your observations. I would argue that in 2008 we rewarded too many of the more psychopathic of the wealthy class who made money both in inflating the bubble and then buying at the bottom. This has worsened a well documented trend of increasing psychopathy, and my own impression that we have too many psychopathic personalities at the top of specific hierarchies of government and health care. This is not good for economic growth.

pgrommit said...

Of course profits are doing great. The Covid shutdown eliminated a huge amount of that pesky small-business competition.

WorthF said...

Scott - Thank you for your consistent sober-minded evaluations. I'm going to point out something Bill Smead and many others have been pounding the table on, concerning concentration in the S&P 500.

You said "Today, however, stocks appear to be appropriately valued, since their actual and nominal valuations are roughly equal."

On an average basis, yes. But there is great danger with the concentration of a capitalization-weighted index or holding model which is NOT going to end well when the music stops. we are experiencing a crowd-investing passivity like we haven't experienced since energy dominance in the early 80's.

Salmo Trutta said...

re: "What explains today's slower growth"

Bernanke destroyed the nonbanks. Think of it in terms of what Reg. Q ceilings did for the nonbanks. The thrifts were given a 3/4 interest rate differential. Today that differential has flipped to the banks via the remuneration rate. So, the transaction's velocity of funds slows.

There isn't a single economist today that understands money and central banking.

Salmo Trutta said...

According to Corwin D. Edwards, professor of economics, Ph.D. Cornell University, the U.S. Golden Age in Capitalism, 1955-1964, was driven by “increased money velocity which financed about two-thirds of a growing GNP, while the increase in the actual quantity of money has finance only one-third.”

Lending/investing by the DFIs expands both the volume and the velocity of new money. Lending by the NBFIs increases the turnover of existing deposits (a transfer of ownership), within the commercial banking system.

It is much more desirable to promote prosperity by inducing a smooth and continuous flow of monetary savings into real investment, than to rely, as we have done c. 1965 on a vast expansion of bank credit with accompanying inflation to stimulate production.

wkevinw said...

Powerful post and comments.

On small biz- yes, small businesses have been in decline for decades. The debt-funded (read zero cost money) startups can get funding for decades via the "markets" (actually govt aided), accompanied by tax and other subsidies (govt aided)- while they lose lots of money. The big companies smash the small ones with clubs they got through "free money".

The QE rounds starting at QE2 forward represent some of the biggest government financial policy errors in history.

Tesla, Amazon, maybe Google, and other big tech companies could not have grown in economic/financial systems/structures prior to about 1995.

Roy said...


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A sit-down with the world’s first libertarian head of state."

Benjamin Cole said...

Great wrap-up.

Yes, hard as it may be to believe, these are the "good ol' days" for corporate profits, and that is a good thing.

I am not a government-basher, although I do believe in smaller government.

But the innovation and push-forward these days is coming from corporations and super- high net worth types. Nevertheless I would eliminate taxes on the first 100k in wages if I was king, and sub in property and import taxes. Maybe fuel taxes.

We are seeing innovation all across the tech world.

I wonder about AI. I am not seeing jack-doodle yet.

wkevinw said...

Some of the employment info is starting to look bad/recessionary. This may give the Fed an excuse to drop rates fairly soon.

Employment markets have looked odd since the pandemic. It's hard to tell whether we are still seeing impact from this, or whether it's from other forces.


wkevinw said...

I am not sure these Fed links work very well. Here's another try:


In a nutshell, employed full time rate is down near recession levels, and employed part time is up near recession levels.

Glenn said...

Seems like labor participation rates enhance the GDP. From 1965 to 2007 we had a growing participation rate, therefore higher GDP rate than today. Both declined after this period. There are millions of unemployed, willingly and unwillingly. To get GDP back on track it seems as if we must get the participation rate higher. Transfer payments go to the unemployed and subtract from GDP. Governments have never been efficient at creating long term jobs nor industries. Therefore its up to private industry to make this happen. Governments either enhance or encumber this with policy. So yes I agree with Scott that the government needs to find a way to lessen the burden on industry to promote such. Otherwise we're destined for a low GDP future.

Grechster said...

A chart of breakevens tells us that the market's outlook for inflation has held in a pretty tight range of 220-250 basis points for the past two years. (I'm citing ten year breakevens but fives tell a similar story.)

Two questions: do you think the Fed will be ok with such a range, given that it's above its stated 2% bogey? I don't see why not as getting down to 2% seems to be too difficult.

And, why the heck doesn't the Fed just tell the market that it's targeting breakevens? They could establish a stated range of acceptability. When the low end of the range is breached, they could ease, and vice versa. It may not be perfect but it would be a whole sight better than relying on 400 PhDs who still have a thing for the Phillips Curve.

Unknown said...

Great post! For Chart #8, what role to you put on demographics, particularly boomers retiring? Thanks!

Salmo Trutta said...

The money stock can never be properly managed by any attempt to control the cost of credit. The FED may have lost control of means-of-payment money in April 2024 (up $264b since Feb).

Scott Grannis said...

Re: Chart #8. I don't think demographics has anything to do with the significant decline in the economy's growth potential beginning in 2009. Demographics don't change on a dime, but policy can and does. 2009 saw the beginnings of a significant increase in government transfer payments. When the government pays people who don't work (that's what transfer payments are all about) then we should expect people to work less.

Scott Grannis said...

Grechster, re breakevens: Breakevens (defined as the difference between the nominal yields on 5-yr Treasuries and the real yields on 5-yr TIPS, which is the market's implied forecast for the average rate of CPI inflation over the next 5 years) of 2.2-2.5% are roughly equivalent to a Personal Consumption deflator inflation of 2%. (The CPI tends to register higher inflation than the PC deflator.) The Fed prefers the Personal Consumption Deflator (Core), so they should view a CPI of 2.2-2.5% as equivalent to a Personal Consumption deflator of 2.0%.

Benjamin Cole said...

Scott Grannis:

Agreed on transfer payments.

Add on: And when governments tax people who work for a living....they get less work effort.

Paying not to work, and taxing people who do work...the ol' one-two punch.

duongquy said...

@Salmo Trutta: Can you recommend some documents or book to understand money, central banks, the structure of the US financial system? thank.

Salmo Trutta said...


Similar to Grannis' demand for money


EHR said...

Agree paying people not to work, who can and should work,is not a good idea. I would argue though that this dynamic is well known and folks are familiar with this robust literature. It is also common sense in a way.

What is less well publicized, and known only to those who study such phenomena, is the increase in psychopathy. I suspect the answer is multi-determined, it is not "either or" but it is "both". If my idea about psychopaths at the top of these hierarchies is correct (please check any of today's headlines), then it suggests many areas of future study and improvement that would actually DECREASE transfer payments. It is win win not zero sum.

Chris_in_NJ said...

Hello Scott: I love your blog! Please excuse me if this sounds rude! Is Salmo Trutta an LLM BOT??? It doesn't make perfect sense 100% of the time & keeps repeating the same cryptic & almost-sensible nonsense over & over in a way that seems almost convincible... but... NO SALE! Is anyone else feeling... uncanny about this cat? (or trout)... or whatever... <-thank you.

Salmo Trutta said...

You obviously don't understand it.

Salmo Trutta said...

On the day the market bottomed, I repeated myself 3 times:
That's B.S.
Bottom's in.
Mar 23, 2020. 10:34 AM
Margin Call: The Story Of A Historic Week - The Heisenberg
Bottom for stocks, not the economy. It will decouple.
Mar 23, 2020. 10:33 AM
We Likely Saw The Bottom - Michael A. Gayed, CFA
The bottom's in.
Mar 23, 2020. 10:28 AM

I've hit almost all bottoms and tops.