Monetary policy is in easing mode, thanks to a significant reduction in inflation pressures. Corporate profits are very strong, and the stock market is making new highs. President Trump's second term promises much-needed and game-changing reductions in tax and regulatory burdens. All good. But threatened tariffs and a significant downsizing of the federal government will create headwinds in the near term; the benefits may take awhile to show up, but they will nonetheless be significant.
Chart #1
Chart #1 updates the M2 money supply through October. The explosive growth of M2 relative to its long-term trend was the proximate cause of the Great Inflation of 2021-22. The federal government effectively printed $6 trillion and sent it to the public, where it sat in the form of currency and bank savings and deposit accounts for almost a year—without creating inflation, since the public had neither the willingness nor the ability to spend it. When life began to return to normal in early 2021, the public began spending the money. Soaring consumer demand—fueled by trillions of unwanted money—collided with supply chain disruptions and shuttered facilities to produce a roughly 20-25% increase in the price level.
The Fed was late to react to the inflationary potential of all this extra money, but eventually they did, by raising interest rates beginning in the first half of 2021. As interest rates soared, M2 growth started slowing in 2022 and even declining. Today it is only modestly above its long-term trend. Inflation risks, accordingly, have plunged.
Chart #2
Chart #2 shows my favorite measure of money demand: M2 divided by the level of nominal GDP. It's akin to the percentage of cash and cash equivalents that the average person or firm wishes to hold relative to their annual income. Very few people look at money demand, but I believe it is crucial to understand the interaction between money supply and money demand. As Milton Friedman taught us, inflation happens when the supply of money exceeds the demand for it. That was precisely what happened beginning in 2021; it was a classic case of too much money chasing too few goods.
Initially, money demand soared as $6 trillion in checks hit people's accounts; the public was willing to hold this money, and that explains why inflation didn't take off until much later. But money demand began to decline in 2021 as economic conditions began to normalize. Today, money demand is almost back to pre-Covid levels, and M2 is growing at a relatively slow pace. There is no longer an imbalance between the supply of and demand for money, and to prove that, we have only to know that inflation has slowed down significantly, even though many prices remain higher than most consumers would like.
Chart #3
Chart #3 shows the three components of the Personal Consumption Deflator, and they tell an important story about inflation. As the chart shows, non-durable goods prices have been unchanged since mid-2022, and durable goods prices have fallen since mid-2022. Only service sector prices have risen in the past 28 months, and most of that rise is due to housing and shelter costs, which have likely been overstated by faulty calculation methods (as I've explained in many previous posts).
A true inflation is when all (or mostly all) prices rise. Inflation today is concentrated in the housing market, which has become relatively illiquid due to high mortgage rates and high prices. Illiquid markets are notorious for not reflecting true valuations. By almost every measure, housing prices today—coupled with sky-high mortgage interest rates—are overvalued and terribly unaffordable.
Chart #4
Chart #4 shows the level of the real Federal funds rate (blue) and the slope of the Treasury yield curve (red). These are excellent indicators of how easy or loose monetary policy is. Money is tight when real yields are high and the yield curve slope is negative (inverted); those conditions have preceded nearly every recession in the past 65 years. Today monetary conditions are becoming less tight and the Fed is very likely to continue lowering the funds rate, with another cut expected at the December 18th FOMC meeting.
Chart #5
Chart #5 shows the yield spread between high-yield and investment-grade corporate bonds (otherwise know as the "junk spread"). Credit spreads have rarely been as low as they are today, and this amounts to very positive economic fundamentals: a healthy economic outlook supports healthy corporate profits.
The contrarian in me suggests a different take: if things can't get much better than this, then maybe the market is overly optimistic and we're due for a fall?
Chart #6
As Chart #6 shows, after-tax corporate profits have been soaring relative to nominal GDP for the past 20 years, and they are now at record-high levels. Corporate profits today are running at a $3.1 trillion annual rate; it's no wonder the stock market has been so strong.
Corporate profits are running at a spectacular rate, but so is the federal budget deficit, which has reached $2 trillion in the past 12 months. Corporate profits are adding $3 trillion every year to the pool of investable capital, but the federal government is borrowing about two-thirds of those profits to finance a variety of income redistribution schemes. This is not a prescription for a strong and growing economy. Imagine what might happen if the private sector of the U.S. economy were able to tap into that $2 trillion for more productive purposes! That is why Trump's DOGE is a terrific idea, but it will likely take some time before budget cuts translate into a positive force for the economy.
Chart #7
Chart #7 compares the level of the S&P 500 index to the level of the European Stoxx 600 index. In the past 20 years, the rise in the S&P 500 index has been 2.5 times that of the Stoxx index. On a total return basis, over the past 20 years the S&P 500 has delivered a 650% return vs. a 315% return for the Stoxx index. Meanwhile, the dollar has gained 25% against the euro over the same period.
Is it any wonder that the U.S. has been able to finance absurdly high federal budget deficits? The U.S. economy has become a magnet for the world's capital.
Given our huge advantage in so many areas, do Trump's threatened tariffs really pose a significant threat to the health of the U.S. economy? More likely, as we have recently seen with Mexico, the mere threat of tariffs is enough to convince Mexico to halt immigrant caravans bound for the U.S. border.
Tariffs can't cause inflation. Only monetary imbalances do. Without a relaxation of monetary policy, Trump's promised tariff hikes won't be inflationary. But tariffs will act as a headwind to growth, since they are effectively a tax on consumption.
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