Monetary policy trumps tariffs

There's no need to worry about Trump's threatened tariffs causing another bout of inflation. Inflation is a monetary phenomenon that can only be caused by excess money, not artificially jacked-up prices. A sound monetary policy deals with rising prices for some things by forcing the prices of other things to decline. It's like living on a fixed budget—if you have to pay more for something that means you have to pay less for others. 

This post reviews the monetary variables that matter most, and concludes that monetary policy is consistent with inflation remaining low and relatively stable; i.e., monetary policy today is sound. Indeed, we are more likely to see lower inflation than higher inflation this year.

M2 growth has normalized, and now is running at the same annual growth rate which prevailed from 1995 thru 2019 (~6% per year)—a time during which CPI inflation averaged 2.5% per year and PCE Core inflation averaged 2.0% per year (PCE Core is the inflation rate the Fed prefers to target). After surging in the wake of Covid stimulus spending and declining as the Fed raised interest rates, demand for money today is only modestly higher than it was in the pre-Covid period, Moreover, money demand appears to once again be stable. Meanwhile, the dollar remains very strong, credit spreads are low, real yields are high, the yield curve is steepening, lending is increasing at a modest pace, and liquidity conditions remain healthy. All consistent with relatively low and stable inflation.

The bad thing about Trump's threatened tariffs is that they could disrupt trade and slow global economies (including ours). If—as many of Trump's supporters suspect—tariffs are a bargaining chip and will prove only temporary at best, then markets may suffer a case of the jitters which should resolve over time. 

Chart #1

Chart #1 shows the level of the M2 money supply, which is widely considered to be the best measure of the amount of spendable money in the economy. The US money supply increased at a roughly 6% annual pace from 1995 through the end of 2019. It then surged in unprecedented fashion as the government sent "stimulus" checks totaling some $6 trillion to households and businesses in an effort to counteract the contractionary impact of Covid -related shutdowns. As stimulus checks ceased in late 2021 and Fed interest rate hikes began to bite, M2 growth not only slowed by turned negative. M2 today stands at the level it first attained 3 years ago, and it is growing at about the same rate as pre-Covid.

Chart #2

Chart #2 shows the level of US currency in circulation, which makes up just over 10% of M2. Currency is the one monetary measure whose demand always equals its supply. Why? Because anyone who finds him or herself with more currency than desired can simply deposit it in a bank account, whereupon it is subsequently extinguished by the Fed. 

What this chart tells us is that the demand for currency rose sharply as M2 surged, but then it declined, and now has returned to a level that is consistent with past experience. Today there is about the same amount of currency outstanding as there would have been if Covid had never happened.

 

Chart #3

Chart #3 is another measure of the demand for money: M2 divided by nominal GDP. By this measure, the demand for money has almost returned to where it was prior to the Covid era. This chart implies that the average person and average business holds about the same amount of spendable cash relative to income (nominal GDP is equivalent to national income) as they did prior to Covid. 

The Great National Money-Printing Nightmare is over, and we sincerely hope it never returns.

Chart #4

Chart #4 shows the 6-mo. annualized rate of growth of the PCE and PCE Core measures of inflation, both of which are within spitting distance of the Fed's 2% target. The Big Inflation of the 2020s is over.

Chart #5

Chart #5 shows the level of the 3 major components of the PCE deflator. Non-durable goods prices are unchanged since mid-2022. Durable goods prices are unchanged since the end of 2021, and have resumed their decline. Only service sector prices are increasing, and those are largely driven by faulty calculations of housing inflation. 

Chart #6

I've been showing Chart #6 ever since I can remember. That's because it shows that every recession in my lifetime has been preceded by a high level of real interest rates (blue line) and an inverted yield curve (red line). It was assumed to be an infallible indicator of a coming recession, but it didn't work over the past several years since the economy has continued to grow. The key difference this time is that the Fed has not caused a liquidity shortage like they did it past tightening episodes. 

real rates push dollar up, comms down wtip5

higher interest rates have done the trick

Chart #7

Chart #7 compares the level of real yields on 5-yr TIPS (not to be confused with the real yields in Chart #6, which are overnight, ex-post real yields) with an index of the dollar's strength against other major currencies. Over the time period shown, changes in real yields have reliably matched changes in the dollar's strength. In order to tighten monetary policy, the Fed must take actions that strengthen the demand for dollars, and the best way to do that is to increase the real yields on investments denominated in dollars. 

Chart #8

Chart #8 compares the strength of the dollar (blue line, same index as the one in Chart #7) with an index of non-energy commodity prices. (I exclude energy prices because they are orders of magnitude more volatile than other commodity prices.) Here we see a strong inverse correlation between the two, except over the past 4-5 years. Given the strength of the dollar, we would have expected to see much lower commodity prices. In my view, the current strength of the dollar is exercising a gravitational pull on commodity prices; over time this is likely to result in cheaper commodity prices.

Chart #9

Chart #9 shows the two most liquid indicators of corporate credit spreads. Spreads have rarely been lower than they are today, which is a strong vote of confidence in the health of the economy and the strength of corporate profits. No sign of an impending recession here. Instead, there is plenty of evidence that financial liquidity conditions are healthy and thus a recession is unlikely.