Thinking about higher interest rates and the demand for money

The Fed has raised rates and the market expects there will be at least 2 or 3 more rate hikes over the course of the next year. This has resulted in a significant increase in market rates of late. Fortunately, the economy is in pretty good shape, thanks to strong corporate profits and a booming AI industry. Housing is the one sector that is threatened, but that's not all bad, because a weak housing market could lead to more affordable prices, lower interest rates, and downward pressure on inflation.

Chart #1

Chart #1 is good evidence that the recent rise in interest rates is not due to higher inflation expectations which have been flat for the past four years or so. What's changed is that real yields have been rising. Why? Most likely because the market is sensing that economic growth is picking up. Stronger growth supports higher rates, and investors demand higher rates to compensate for more attractive returns on productive assets. 

Chart #2

Chart #2 compares ex-energy inflation to 5-yr Treasury yields. Clearly, this measure of inflation has very little influence on yields. I use ex-energy inflation because energy is by far the most volatile component of the CPI. What's important now is that interest rates are unquestionably high relative to underlying inflation, and this has important ramifications for monetary policy.

Chart #3

Chart #3 compares the year over year change in the CPI to a version of the CPI that excludes food, energy, and shelter costs. Food and energy costs have been strongly influenced by the Iran war disruptions, and shelter costs have been skewed higher for years because of faulty methods employed by the BLS. This measure of inflation is well-behaved and that in turn argues against further rate hikes.

Chart #4

Chart #4 compares the pace of economic growth (red line) to the real yield on 5-yr Treasuries (blue line). Real yields have a strong tendency to rise and fall as economic growth rises and falls.

Chart #5

Chart #5 uses a logarithmic scale to make it easier to identify underlying growth trends in real GDP. Note that in the past several years real GDP growth has been slowly trending higher vs the trend in place from 2009 through 2023. This partially justifies the recent rise in real yields. 

Chart #6

Chart #6 shows credit spreads on investment grade and high-yield corporate bonds. Spreads are relatively low, and that is consistent with a strong economy and a healthy outlook for corporate profits.

Chart #7

Chart #7 shows Bloomberg’s measure of financial conditions (positive values being good, negative values being bad). By this measure financial markets look quite healthy, and that again is consistent with a strong economy and a healthy outlook for corporate profits. 

Chart #8

Chart #8 shows how fixed-rate mortgage rates are strongly influenced by the 10-yr Treasury yield. Mortgage rates are now in the region of 7.5%, and that is putting a lot of pressure on the housing market. Housing is arguably the most threatened part of the US economy. Prices are relatively high, and with soaring interest rates, affordability is historically low. New home construction is weak, and that is keeping supply tight and that helps support prices. Something has to give, and I think it will be prices—which could fall significantly in coming years. Interest rates will likely decline as well, once the Fed realizes it won't need to tighten further.

Chart #9

There's a silver lining to the housing sector cloud, however. As Chart #9 shows, housing prices are quite high historically, both in real and nominal prices. However, prices look like they have peaked, or at best are only rising modestly. Homeowners familiar with basic math should realize that if home prices fail to rise by a rate that equals or exceeds their cost of money then they will experience a negative return on their housing "investment." Furthermore, borrowing 80% of the price of a house equates to significant leverage (5 to 1), which in turn magnifies any negative return on housing. Viewed from my perspective as a monetarist, this housing "squeeze" is a sure-fire way of supercharging the demand for money (because it depresses the demand for loans), and that in turn should help bring inflation down. Why? Because borrowing money is equivalent to a negative demand for money; thus, the less people want to borrow, the higher their demand for money.

Private sector jobs are still growing

The headline jobs numbers were disappointing on the surface (+29K actual vs +90K expected). But one month's worth of data is not enough to know what the underlying trend is—jobs are notoriously volatile from month to month. I prefer to look at the 6- and 12-month growth rates of private sector jobs; those are the ones that matter. Government jobs have been stagnant for the past six months, and are down 1% over the past year. Flat to down government jobs are actually something to cheer about.

Chart #1

As Chart #1 shows, private sector jobs growth has actually been improving since earlier this year.

However, the rate of improvement is still quite modest, and hardly enough to warrant or justify another Fed rate hike at the next FOMC meeting in late October. 

Jobs growth update: modest improvement in August.

Private sector job growth (the only jobs that really count) exceeded expectations in August (+127K vs +50K), but the overall picture remains the same: jobs growth over the past year or two has been very weak, but it has been improving over the course of the past year. The economy has regained its footing after the illegal-immigrant crackdown and the turmoil induced by Trump's tariffs and the war in Iran. 

To judge by today's reaction to the news, the bond market thinks that today's upside jobs surprise increases the chances of a Fed rate hike at the next FOMC meeting (September 16) from 50% to 60%. I disagree. If anything, I would argue that jobs growth remains so weak that a rate hike might pose a threat to the economy. Recall that two years ago the Fed began a series of six rate cuts which ended last December. That was likely the catalyst that arrested the decline in jobs growth which began in early 2022. Also recall that there is a "long and variable lag" between monetary policy changes and their impact on the economy.  

Nevertheless, jobs growth these days pales in importance compared to the rate of inflation. Expectations for next Friday's CPI report call for little or no change from last month's 3.4% y/y for total, and 2.4% for core—both currently running at only slightly more than Warsh's target. Meanwhile, the housing market continues to suffer from very slow sales growth, weak residential construction, elevated mortgage rates, and flat to falling home prices. These latter factors are likely to act as a continued headwind to the government's CPI calculation, as they have been doing for the past several years.

It's a good thing that Fed Chair Kevin Warsh is hyper-focused on reigning in inflation, but I don't think he will interpret these developments as a reason to raise rates any time soon. 

Chart #1

Chart #1 compares the level of private and public sector jobs. Of note, private sector jobs growth has been tepid in recent years, while public sector jobs—particularly at the federal level—have suffered a significant decline, thanks to Trump’s efforts to trim the federal workforce, which has shrunk by almost 2.7 million on his watch and hasn't been this small since 1966! 

Chart #2

Chart #2 compares the growth rate of private sector jobs, measured on a 6-month annualized and a year over year basis. (Doing this is essential to filter out the notorious “noise” in the monthly data.) It is becoming clear that the economy's vitality reached a low ebb in late 2025 and has since begun to recover. 

A Goldilocks economy?

When I review recent news and ponder the meaning of the charts below, these are the thoughts that come to mind:

The M2 money supply is well-behaved—the excesses of the Covid era have been absorbed—and it is once again growing at a rate that in the past has been consistent with relatively low inflation. Interest rates at current levels (5-yr Treasury yield ~4.5%, 10-yr ~4.7%) seem about right given a relatively slow-growing economy and inflation of 2-3%. Corporate profits are on the moon—literally off the charts. Stocks are fairly valued, maybe a bit rich, given the current level of interest rates. Unemployment is low and falling. Jobs growth is slow (1.5-2%) but increasing. The Fed is not making any big mistakes. Woke energy policies are fading fast, even in Europe, and AI is spreading like wildfire. Global economies are thus likely to enjoy a tailwind for the foreseeable future. Is this a Goldilocks economy, or what?

Chart #1

Chart #1 compares the level of 5-yr Treasury yields to the ex-energy rate of inflation. (Energy is by far the largest contributor to the ups and downs of inflation, and the war in Iran has only made matters worse.) Interest rates at current levels have kept inflation in check in the past, and now seem likely to exert a bit of down pressure on inflation going forward. Regardless, I continue to believe that the inflation statistics overweight and over-measure shelter costs, and that problem is slowly receding.  

Chart #2

Chart #2 shows the level of the M2 money supply plotted on a logarithmic scale to highlight its fairly constant growth rate over time. M2 grew by about 6% a year from 1995 through 2007, and during that time inflation was relatively low and stable. Today, M2 is only slightly above its long-term trend. 

Chart #3

Very few analysts track the relationship of M2 to nominal GDP. I think it is a good measure of the demand for money, and that is key to being able to understand whether the Fed is doing its job with the money supply. (Inflation happens when the supply of money exceeds the demand for it.) Money demand is back to where it was prior to the Covid era. Coupled with the 6% growth rate of the M2 money supply, this leads me to the conclusion that monetary policy likely is in a sweet spot for now. (Long-time readers will know I have been saying this for the past several years.)

Chart #4

Chart #4 shows the ratio of economy-wide corporate profits (a key component of the GDP accounts) to nominal GDP. Think of this as a proxy for corporate profit margins. Corporate profits are at historically high levels, and more than twice what they were in the 1970s and 1980s, as the dashed green lines show. No economist in his right mind would ever have predicted this, and I certainly didn't. With corporate profits at record levels and growing, is it any wonder that the stock market is making new highs?

Chart #5

Chart #5 shows the level of the S&P 500 index plotted on a logarithmic scale. The green line is a stand-in for the long-term growth trend of this index (~8% per year). Pay particular attention to the 2008-2009 recession, and how this resulted in a severely depressed stock market. Now note that the S&P 500 has come back to its long-term growth trend; this is why stocks have had such a strong run over the past 17 years.

Chart #6

The red line in Chart #6 compares the actual market capitalization of the U.S. stock market using the S&P 500 index as a proxy, while the blue line is the result of capitalizing the measure of corporate profits that I have used in preceding charts. To capitalize profits I divide corporate profits by the 10-yr Treasury yield)*. Note that the market cap was significantly lower than capitalized profits from 2009 through 2024; this corresponds to an underperformance relative to trend from 2009 through 2024 that shows up in Chart #5. It is certainly likely that the undervaluation of stocks during that period was exaggerated by the fact that the Fed was mistakenly keeping interest rates historically low for a number of years.

None of this is science, to be sure, but from two different perspectives it seems that as of a few years ago, stocks have returned to prior trends and are now more or less fairly valued. This could of course change if the Fed were to significantly raise interest rates, since that would reduce capitalized profits and in turn depress stock prices.

* Reasonable people could argue about which yield to use when capitalizing profits, but I think the 10-yr Treasury yield is as good as any. I credit Art Laffer with bringing this method of equity valuation to my attention many years ago: he used it in early 2000 to correctly argue that stocks were overvalued and due for a fall.

UPDATE: (Aug 28 '26): 

Chart #7

Chart #7 is Bloomberg's Financial Conditions Index, which tracks just about everything you would want to know about financial conditions. The latest reading is just shy of a multi-year high, which is exactly what you might expect to see in a Goldilocks economy. 

Key facts about federal debt you might have missed.

Our national debt is once again in the news, since it has supposedly reached a staggering $40 trillion. I say "supposedly" only because that's not really true. $40 trillion is the amount of Public Debt Outstanding, which includes $7.75 trillion of Intergovernmental Holdings (which means the debt that one branch of the government owes to another). The true measure of federal debt is Debt Held by the Public, which is now $32.3 trillion. You can see the history of all these numbers here. 

I offer the following charts—some of which you've likely never seen before—to help one understand our national debt and its implications.

Chart #1

Chart #1 shows a long history of federal debt owed to the public. It's plotted on a logarithmic scale so you can appreciate how fast or slow it's been growing over time. Over the period shown, federal debt has increased by an annualized rate of 8.8% per year. Note that the growth of federal debt in recent years is not very different from what it's been over the past seven decades on average. 

Chart #2

Chart #2 shows the evolution of federal spending and federal revenues since 1990. It's also plotted on a logarithmic scale. The difference between the two lines is the federal deficit, which in the past 12 months has totaled $1.95 trillion. Note that spending has slowed dramatically since 2022, while revenues have been grown significantly in the past few years.

Chart #3

Chart #3 shows federal spending and federal revenues as a percentage of GDP. The dashed lines show post-War averages for both. Federal revenues relative to GDP today are only slightly lower than they have been for many decades, but federal spending is substantially higher. From this fact alone it's not a stretch to say that the main reason we have a large federal deficit is that federal government is spending very high from an historical perspective.

Chart #4

Chart #4 shows federal revenues as a percentage of GDP vs. top federal income tax rates. Remember the hue and cry when President Reagan slashed tax rates in the 1980s? Supply-siders like Art Laffer argued that lower tax rates would be such a stimulus to growth that revenues would remain strong. Left-wingers argued that the deficit would explode. Based on this chart it's easy to say that if anything, lower tax rates led to a surge in tax revenues from 1983 through 2000. It's the Laffer Curve in action; if tax rates are too high, then lowering them will lead to more growth, rising real incomes, and higher tax revenues. Tax rates were clearly too high in the decades leading up to the 1980s.

Extrapolating from Charts #3 and #4, the worst thing the federal government could do to reduce the deficit is to raise tax rates. Lower spending is the only sensible course of action.

Chart #5

When people speak about the burden of the federal debt, they usually refer to the size of the debt relative to the size of the economy. That's shown in Chart #5. Today federal debt is a smidgen less than the size of our economy. It's only been higher during WW II. But that's not a good measure of our debt burden.

Chart #6

Chart #6 shows interest payments on federal debt as a percentage of GDP, which is the correct way to measure the burden of our debt. Note that it was much higher in the 1980s than it is today. That's because interest rates were much higher back then than they are today. Example: having a mortgage that is equal to 30% of your annual income is much harder if mortgage rates are 8% than if they are 6%. Chart #7 gives you the history of 10-yr Treasury yields to help keep these facts in perspective.

Chart #7

Is our federal debt out of control? a ticking time bomb? No. It's still manageable, but we would all be much better off if the federal government downsized its spending and reduced our tax and regulatory burdens. 

Jobs growth picking up a bit

The June payroll data released a few days ago bolsters the thesis that jobs growth is picking up. Jobs growth is still modest by historical standards, but it is improving, not deteriorating, and that is significant. 

Chart #1

Chart #1 shows the year over year and 6-mo. annualized rate of growth of private sector jobs. Given the volatile nature of month-to-month rates of change of this statistic, I think it is best to view it from a multi-month rate of change perspective. We now see that by both measures, jobs growth is picking up a bit. But at best, the current rate of growth is still less than 1% per year. 

Chart #2

Chart #2 shows the level of private sector and public sector jobs. Here we see that private sector jobs have picked up a bit, whereas public sector jobs have lost ground in the past year or so, thanks to Trump's efforts to downsize the federal bureaucracy. 

I don't see anything here that would justify or warrant a change in short-term interest rates. The economy is not on the verge of a sudden acceleration, nor is it on the verge of a downturn. 

Meanwhile, key indicators of inflation pressures bolster the case for lower inflation: non-energy commodity prices are down 4.5% from their pre-Iran levels, 5-yr breakeven inflation rates have fallen to 2.3% from an Iran-war high of 2.75%, and gold prices are down 10% and the dollar is up 3.5% since the end of February.

Interesting chart updates

We're back from a long trip to Argentina. Since we were there two years ago, the only thing that has changed in a meaningful way is the peso, which has effectively appreciated by a significant amount—another way of saying that the prices of just about everything have gone up a lot in dollar terms. The exchange rate back then was 1500 pesos to the dollar, and it's the same today. But there has been inflation (in peso terms) of 40-50% in the intervening two years. This has been made possible by a 50% increase in the central bank's foreign exchange reserves in the past two years. The central bank has been buying up a portion of the dollars that have been pouring into the country. I see lots and lots of new foreign investments coming into Argentina, and these will translate into more and more jobs and prosperity in the coming years.

Other than that, there are interesting parallels between Argentina and the United States. Prices are up, lots of people are complaining, jobs are hard to find, and a lot of people are upset with their president. Fortunately, no one is talking about a coup or the possibility that Milei will reverse course. Meanwhile, life goes on, there's plenty of traffic, the food is delicious (wine, notably, is very cheap and very good), and the people are extremely friendly. We took a 3-day side trip to Cafayate, which is the #2 wine region in the country. It's in the northwest part of Argentina, near Salta. It's gorgeous and worthy of a visit for anyone who loves wine and mountain views. (Our favorite winery, San Pedro de Yacochuya, is located at about 7,000 feet elevation.) I did note, however, that restaurants are not packed at 10:30 pm as they would be if everything were normal. 

What follows are some charts I've been working on in the past few days. Nothing of great concern emerges from this review. Inflation fundamentals haven't changed, the economy is doing Ok (1.5-2% real growth), corporate profits are tremendous, and there are no signs of a looming recession or even a slowdown. 

Chart #1

In the past several months there has been a notable pickup in the growth of the M2 money supply. So far it's nothing to be concerned about, especially in an historical context. But it bears watching.

Chart #2

Chart #2 is my way of calculating the demand for money: it's the ratio of the M2 money supply to GDP. It hasn't changed much in the past few years, and is only marginally above pre-COVID levels. I would be concerned if it were falling, since that would imply that the Fed would need to increase interest rates in order to persuade the market to hold money instead of spending it. 

Chart #3

Chart #3 shows the growth trends of the three main components of the Personal Consumption Expenditure Deflator, the Fed’s preferred measure of inflation. Note that durable goods prices (cars, appliances, etc.) have been unchanged since 2022, while non-durable goods (food, clothing, gasoline, etc.) prices have also been largely unchanged EXCEPT for the last few months, during which time the Iran conflict has boosted energy prices. Inflation in recent years has been driven primarily by service prices, which in turn have been driven primarily by labor and shelter costs. 

Chart #4

Chart #4 compares the number of job openings to the number of job seekers. This suggests that labor market conditions haven't changed much in the past two years. No boom, no bust. No abundance of new jobs, but no contraction either.

Chart #5

Chart #5 shows the level of nominal and real (inflation-adjusted) housing prices in the United States. In real terms prices have actually declined a bit in the past several years, while in nominal terms prices have been rising at a slower and slower pace. It’s clear to me that we are seeing top in prices, which will likely be followed by a period declining prices. It's often said that the housing market goes through cycles like this about every 10 years. And of course, with declining prices, shelter costs will be declining and contributing to lower inflation. 

 

Chart #6

Chart #6 compares the prices of bitcoin and the S&P 500. Bitcoin prices are down by two-thirds from their high last year, while equity prices continue to rise. As the chart notes, holders of bitcoin have lost about $2 trillion since the peak. Ouch. I have been a resolute bitcoin skeptic for a long time, and I'm tempted to say that we haven't seen the worst yet. Bitcoin was never more than a speculators' game that had some mathematical credibility but little else. Given its volatility to date, it is not a reliable store of value nor a hedge against anything. Bottom line: bitcoin has no inherent value.

So: what does this mean? I am an inveterate optimist, so I tend to see this as a good thing. Speculators are getting whupped, and they are being forced to retreat to good old-fashioned things that are tied to productive assets and productive activity. That's another way of saying that the bitcoin bubble popping is generating an increased demand for money. At the very least that further suggests that the Fed does not need to raise interest rates; with no change in rates but a big upward shift in money demand, monetary conditions in the US are effectively tightening. That's one more reason why I think inflation fundamentals remain intact and sound.

Chart #7

Chart #7 shows the ratio of corporate profits to GDP, which now stands at a record all-time high. Note how the ratio in recent years has been about twice as high as it was in the 70s and 80s. That is a huge deal. No wonder the stock market is doing so well!

Inflation likely to subside, growth likely to improve

Rising real interest rates and falling non-energy commodity prices are laying the foundation for lower overall inflation. Meanwhile, there are encouraging signs of improving economic growth conditions.

Chart #1

Chart #1 is all about interest rates and inflation expectations. Interest rates have been rising of late, but not because inflation is rising. We know this because real interest rates have risen much more than nominal rates in the past several months. The top (white) line shows the nominal yield on 5-yr Treasuries, while the orange line shows the real yield on 5-yr TIPS. The line at the bottom of the chart is the difference between the two, which is the market's expectation of what the CPI will average over the next 5 years. 

Inflation expectations reached a peak in mid-March of this year, boosted by sharply higher oil prices, which in turn were a by-product of the Iran conflict. Those expectations were (briefly) validated by the March, April and May CPI releases. But inflation fundamentals are already reversing for the better. 

Chart #2

Chart #2 shows the price of gold (white line) and non-energy commodity prices (orange line). Both were rising smartly from September '25 through February of this year, even as measured inflation and inflation expectations remained muted. I'll admit to worrying last year that rising gold prices were throwing shade on my low-inflation predictions. Gold, as everyone knows, has throughout history been a refuge from inflation and economic and political risk. I didn't see either, thinking gold was simply getting carried away by momentum dynamics. Now, however, it turns out that gold was prescient: tensions in the Middle East were heating up and boiled over at the beginning of March. 

The other side of this story, though, started playing out in late March as gold prices dropped, followed a month or so later by falling non-energy commodity prices. Gold and non-energy commodity prices may well be telling us that Middle East tensions are declining and—thanks to higher real interest rates which have effectively tightened monetary conditions—we are soon likely to see falling inflation. And perhaps, as Charts #4 and 5 suggest, an improving economic outlook. Who needs gold, now that the war is winding down. (Buy at the sound of cannon, sell at the sound of bells.)

 

Chart #3

Chart #3 reinforces a more optimistic outlook. As the chart shows, real interest rates (orange line, 5-yr real rates on TIPS bonds) have a strong tendency to strengthen or weaken the dollar (white line). Higher real rates simply make a currency more attractive to own and less attractive to borrow. The recent rise in real rates suggests that the dollar is likely to strengthen. A stronger dollar, in turn, would reinforce a lower inflation outlook because a strong dollar is symptomatic of strong demand for money. And with the M2 money supply growing at a modest rate, strong dollar demand means an effective shortage of money that might otherwise fuel rising prices.

Chart #4

Chart #4 shows the ISM manufacturing indices for the US and Europe. Both have risen of late, strongly suggesting improving conditions in the manufacturing sectors.

Chart #5

Last week's release of the May jobs statistics lends further support to the strengthening economy thesis. Jobs growth appears to have turned the corner for the better. It's still very weak, of course, but things are improving on the margin and that is the most important fact. 

*********

As an aside, we are in Argentina right now visiting friends and relatives. The macro fundamentals, as I see them—lots of foreign investments inflows, rising central bank reserves, and a stable currency (the peso has actually strengthened meaningfully since I was last here two years ago)—suggest the economy is very likely to improve in the months and years ahead. Yet people are terribly frustrated, as they are in the US as well. Change is always painful at first. 

More on Argentina to come.

Key macro charts update: still looking good

Consumer confidence is low, and surveys find that the majority of the US population thinks the economy is getting worse. According to Rasmussen, only 43% approve of the job Trump's doing. Gas prices are high—the other day I paid almost $7/gal—and there are widespread reports of consumers cutting back on non-essential goods and services. Reported inflation has jumped, and the market fully expects the Fed's next move will be to raise rates. Despite this grim backdrop, the stock market is making new highs almost daily (the S&P 500 is up 28% in the past year!), and corporate profits are simply fabulous. I can't remember another time with such a disconnect. 

It's time to review some important macro indicators:

Chart #1

Chart #1 shows that the M2 money supply continues to grow at a moderate pace—up just 5.1% in the past year, and in the past two years up a mere 4.3% annualized. Headline inflation has jumped, however, thanks to the complications of the Iran war which have sharply reduced the global supply of oil. If the Fed under new chair Kevin Warsh stands firm, higher prices for energy will not trigger a broad-based rise in prices. Meanwhile, the market has effectively tightened monetary policy by pushing 5-yr real interest rates up by 50 bps since the end of February, and by pricing in the near-certainty of a one quarter point tightening over the course of the next 12 months. 

From 1995 through 2019, the M2 measure of the money supply grew at a compound annual rate of 6%, a period characterized by relatively low and stable inflation. The money supply then exploded by some $6 trillion from 2020 through early 2022 as the federal government sent out Covid "stimulus" checks that—at first—sat idle in bank checking and savings accounts. As consumers and businesses regained confidence and the economy emerged from the Covid shock in early 2021, that extra M2 eventually became monetized, and that in turn provided the fuel for a sharp rise in inflation.

Today, M2 is only about 5% ($1.2 trillion) above where it likely would have been in the absence of the great Covid monetary shock. The Covid-related explosive increase in money has been absorbed by higher prices and a growing economy. Monetary policy has been back on track for several years now. This is key to the inflation outlook.

Chart #2

Chart #2 shows real (blue) and nominal (red) 5-yr Treasury yields, and the difference between the two (green) which is effectively the market's expectation for what the CPI will average over the next 5 years. Just before Covid hit in early 2020, inflation expectations were relatively low—about 1.6%. The Covid shutdowns at first caused inflation expectations to plunge to near-zero, then to soar to 3.7%. Today the bond market is priced to inflation averaging 2.54% over the next 5 years—only modestly above levels that the Fed should be prepared to tolerate. People may be worried about rising inflation, but not the bond market. 

Chart #3

Capital goods orders (Chart #3) are key to economic growth and prosperity, since new machinery, factories, and computers are what will drive future productivity. In inflation-adjusted terms, capital goods orders have been usually weak since the turn of the 21st century. Is it surprising that the economy has managed only moderate growth in the current business cycle which began in 2009. The recent strength in this series is a welcome breath of fresh air, and a sign that economic growth may continue to improve in the months and years ahead.

Chart #4

Chart #4 breaks down the Personal Consumption Deflator (the Fed's preferred measure of inflation) into its three major components. Things to note: since 1995, when China's economy started opening to the world and unleashing a flood of cheap electronics and appliances, the prices of durable goods have fallen by 30%. Meanwhile, service sector prices have risen by 141%, a direct result of rising real wages and a growing economy. Until the start of Iran hostilities, non-durable goods prices rose a bit less than 1% per year since mid-2022. Bottom line: outside of wages, and prior to the Iran war, inflation was largely confined to service sector prices, which in turn are largely determined by wages. These facts suggest that in the past 35 years, an hour's worth of wages now buys almost three and a half times more durable goods and 30% more nondurable goods. Wow.

Chart #5

Chart #5 is one of my favorite charts. The dotted green line reflects the growth trajectory of the US economy from 1965 through 2007, when the economy grew at a compound annual rate of about 3.1% per year. The dotted red line in the trajectory since the end of the Great Recession in mid-2009, when the growth trend abruptly slowed to 2.3% per year. If our economy had followed the 3.1% growth path, it would be 23% bigger today. The likely causes of this dramatic underperformance? Inefficient green energy subsidies, a huge increase in transfer payments, and increased tax and regulatory burdens figure at the top of my list. The recent strength in capital goods orders is the first indication that the economy may be regaining its former vitality.

Chart #6

Chart #6 shows corporate profits as a percent of nominal GDP. Think of this as a proxy for corporate profit margins: for every dollar of GDP, corporations today capture more than 11 cents of after-tax profits. That's  twice as much as during the 1970s and 1980s (as indicated by the dashed green lines). No wonder the stock market is making record highs! Corporate profits have never been so healthy. Wow.

Chart #7

Chart #7 shows the year over year change in the overall Consumer Price Index as compared to its ex-energy version. Energy has always been the most volatile component of the CPI, and today is no exception. The important thing here is that energy prices do not cause inflation. Monetary policy is the chief determinant. And as we have seen in prior charts, there is no sign that monetary policy has become inflationary. The ex-energy version of the CPI is up 2.8% in the past year, and that is only marginally higher than the 2.5% inflation expectations priced into the bond market. Bear in mind that this number continues to be artificially inflated by the flawed measure the BLS uses to calculate shelter costs. Nationwide housing prices are up by a mere 0.7% in the past year; on an inflation-adjusted basis, housing prices are down 3.7% from their peak in mid-2022. These facts have yet to be captured by the BLS, which uses the year over year change in housing prices from 18 months ago to compute shelter costs.

If you focus less on the headlines in the media and more on the underlying statistics, the picture becomes clear: the economy is in good shape and likely to get even better.

M2 update: still looking like inflation will remain low

Here's an updated look at key charts and indicators that I have been following for the past several years. All continue to suggest that inflation is likely to remain relatively low. Moreover, whereas the economic outlook had been looking rather modest, there are now welcome signs of an economic pickup on the horizon; this builds on the fact that corporate profits have been quite healthy of late. 

Chart #1

Chart #1 shows the growth of the M2 money supply, which is generally considered the best one to follow. For the past 3-4 years I've noted that the Covid-related "bulge" in M2 was disappearing, and that is still the case. The relationship between money and nominal GDP has almost returned to where it was pre-Covid. Recall that from 1995 through 2019 M2 grew at a 6% annual pace, while the CPI averaged about 2%. 

Chart #2

Chart #2 shows the 6-mo. annualized change in M2. Currently at 4.7%, it is still comfortably below 6% and shows no signs of any worrisome uptick. The Fed lost control of M2 from 2020 through 2021, but it has been back in control for the past several years.

Chart #3

Chart #3 illustrates what I call "money demand." It is the ratio of M2 to nominal GDP, and can be thought of as the amount of risk-free money and money equivalents that the average person or corporation wishes to hold, expressed as a percentage of annual income. Here we see that money demand is almost all the way back to its pre-Covid level. A powerful increase in money demand drove the ratio higher from 2020 to 2021, and an equally powerful decline in money demand (which in turn has been driven by a decline in risk aversion) has driven the decline in the ratio since 2022. Money demand appears to be stabilizing at a time that money supply is growing at a relatively slow pace. This argues strongly for there being an absence of any monetary source of rising inflation. Higher oil prices are certainly driving energy-related prices higher, but this is not symptomatic of an untoward rise in the general price level. I suspect that the longer oil prices remain elevated, the more stories we will hear of price declines in other areas of the economy. The economy's monetary "budget" does not allow for an overall increase in prices beyond what we have been seeing in recent years.

If anything, the war in Iran is more likely to increase the public's demand for the safety of money and money substitutes. In the absence of any acceleration in the supply of money, it is very hard to make the case that inflation overall is going to rise.

Chart #4

Chart #5

Capital goods orders are good evidence of corporations' willingness to invest in new plant and equipment (and software, aka artificial intelligence these days). Chart #4 uses a 3-mo. rolling average of monthly order levels for nominal and real values, whereas Chart #5 shows the actual monthly nominal values. Note how strongly orders have increased of late (Chart #5). This is big news, and strongly suggestive of a stronger economy in the years to come.

Chart #6

Not all is rosy, however. Chart #6 shows real and nominal nationwide housing prices (the index measures average prices in the three months leading up to the reporting period, so it is somewhat lagging the reality today). Real prices have been flat for several years, and nominal prices are up only 0.7% in the past year. This sure looks toppy to me.

Many millions of people own their homes, and these days they are paying a pretty penny to do so. One look at this chart tells you that home price appreciation has dropped to almost zero. Taking inflation and interest rates into account, owning a home is not only expensive (e.g., property tax, insurance, and mortgage interest) but also extremely burdensome. 

If you are paying over 6% to finance an asset that is not going up in price (and may soon go down), you are leveraged into a losing bet. Even if you have a 3% mortgage, the opportunity cost of money these days is closer to 5 or 6%. A "conservative" home purchase made with a 20% down payment and a 6.25% mortgage today equates to using 5-to-1 leverage. So the expected return today of owning or buying a house is approximately 6% less than what it is costing you, multiplied by a factor of 5 if you are using leverage to own it. If home prices stay flat for the next few years, you will be losing roughly 30% (6% times 5) of your down payment each year. (OK, for those who can deduct mortgage interest it's not quite so bad, but still ... and don't forget insurance—which has become extremely costly if unattainable for many—plus property taxes and maintenance.)

This is not a pretty picture.

Chart #7

Chart #7 shows the housing picture in a different light. Here we see that housing starts have been stagnant to somewhat lower for the past several years, and homebuilders are not very optimistic at all that things are going to get better. Plus, home sales have been very weak for years. Strong demand for housing coupled with a limited supply has forced prices higher, but that dynamic is running out of steam. Leverage worked to buyers' advantage from 2013 through 2021, but now the tables have turned. Things won't get better until mortgage rates decline meaningfully and/or home prices decline.

Chart #8

As Chart #8 reminds us, thanks to the BLS's method of calculating owners' equivalent rent, the OER contribution to the CPI is beginning to subtract from reported CPI inflation.

GDP update (4/30/26): the economy grew at a moderate 2.0% annualized rate in the first quarter. As the chart below shows, the economy has been growing at about a 2.3% annualized rate ever since the middle of 2009 (i.e., the end of the Great Recession). 

Chart #9

The green line is an extension of the trend that prevailed from the mid-60s through 2007. If the economy had followed that path, it would be 24% larger today. We've had 17 years of sub-par (by historical standards) growth. Let's hope that Trump's efforts to trim tax and regulatory burdens, coupled with the "magic" of Artificial Intelligence can boost our future growth path.