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.