Slow M2 growth fuels stronger economic growth with low inflation

Yesterday's release of the December M2 money supply figures showed a continuation of the sub-6% growth trend that has been in place since inflation peaked in mid-2022. Despite over three years of very sluggish money growth, economic growth has exceeded most expectations. Why? Because money that was stockpiled during the Covid winter has been steadily released to fuel increased economic activity, while at the same time inflation has remained relatively low and federal deficits are shrinking.

The monetary and inflation fundamentals are pretty darn good these days, with the possible exception of the dollar, which has weakened on the margin in recent months. I am not worried about that, however, because the dollar remains substantially stronger than its long-term average in trade-weighted and inflation-adjusted terms. I'm not worried either about the surge in gold prices, which have recently surpassed $5,300/oz and appear to exist in an alternate universe. Abstracting from gold, commodity prices are well-behaved and show no sign whatsoever of inflationary behavior.

The following charts expand on these observations:

Chart #1

Chart #1 shows the level of the M2 money supply, plotted using a logarithmic y-axis to better illustrate how money grew at roughly a 6% annual rate from 1995 through 2019—a period during which inflation was well-behaved, averaging about 2% per year. M2 growth exploded beginning in 2020, as the federal government began "printing" some $6 trillion to fund massive transfer payments. The Fed finally woke up to this problem and began to hike interest rates in 2022, and money-printing ceased. Result: M2 is largely back to where it would have been had the Covid fiasco never happened.

Chart #2

Chart #2 is constructed to illustrate how inflation has tended to lag changes in money supply growth by about one year. The initial surge in money growth was not immediately inflationary because huge Covid-related uncertainty caused economic actors to stockpile money. In other words, Covid led to a huge increase in money demand—which meant that a huge increase in money supply was neutralized by a correspondingly huge increase in money demand. But after a year or so, money demand subsided and the money that had been stockpiled began to be spent, and that fueled rising inflation. Today we're essentially back to "normal," thanks to higher interest rates and saner fiscal policies. 

Chart #3

Chart #3 shows the 6-mo. annualized rate of change of the M2 money supply. Money growth has been very slow ever since inflation peaked in mid-2022, and although it has picked up in the past few years, it is still below the 6% trend that prevailed in the 1995-2019 period. The Fed made a huge inflationary mistake in the 2020-2022 period, but they now have the situation back under control. A flareup in inflation against a backdrop of 4-5% M2 growth, positive real interest rates (the 5-yr TIPS yield today is 1.3%), and declining federal deficits is therefore highly unlikely. Great news!

Chart #4

Chart #4 illustrates what I have called "money demand." It is the ratio of M2 to nominal GDP, and it can be thought of as a proxy for the amount of spendable money the average person or business wishes to hold relative to their annual income. Today money demand stands at just over 70%, having fallen from a peak of just over 90% in 2020. It is almost back to pre-Covid levels. Today there's no excess supply of money, and the demand for money has returned to levels that are much more normal. Result: low inflation for the foreseeable future. 

Chart #5

Chart #5 shows rolling 12-month totals for federal government spending and revenues. After exploding higher in 2020, federal spending has largely stabilized in recent years. Spending peaked at $7.62 trillion in March 2021, and last year spending totaled $7.05 trillion—that's almost five years of no spending growth! Over the same period, revenues surged from $3.52 trillion to now $5.38 trillion. As a result, the federal deficit has fallen from a high of $4.1 trillion in March 2021 to now only $1.7 trillion. That's still way too much, but it is almost certainly going to decline further. We're slowly getting back to normal. 

Chart #6

Over the past year, the dollar has fallen by roughly 10%. Normally that would be a cause for concern, especially since I believe that a strong currency is always better than a weak one. But as Chart #6 shows, when you adjust for inflation, the dollar is still trading about 15 to 18% above its long-term average. In a way, the dollar has gone from being very strong to just strong. I was relieved to hear Treasury Secretary Bessent today reiterate that a strong dollar is in our nation's best interest. 

Chart #7

Chart #7 shows the 75-year history of the S&P 500 index, which has grown by about 8% per year. It's a bit on the strong side of that trend, but nothing here looks particularly worrisome. Investors see a stronger economy, and they are voting with their feet. Makes sense.

Chart #8

Chart #9

Charts #8 and #9 are constructed in similar fashion. The blue line is the inverse of a popular dollar index (i.e., upward moves signify weakness, and downward moves strength in the dollar), while the red line in the first chart shows the inflation-adjusted price of gold, and in the second chart, the red line shows an inflation-adjusted index of a basket of 22 basic commodities. Note that in Chart #9, inflation-adjusted commodity prices have a strong tendency to move inversely to the changes in the dollar's value. (The nominal (non-inflation-adjusted) version of that same index has been flat for the past 4-5 years even as the dollar has weakened.) 

Gold and silver today are the only major commodity prices (with the notable exclusion of copper, which is facing heavy demand from AI-related industries) that are going up—and dramatically so. One important conclusion: gold and silver are fundamentally different from things like soybeans and sugar. Their rising prices do not necessarily imply a weaker dollar or higher inflation.

From this it follows that gold and silver should not be lumped together with other commodities. They just don't behave in the same manner. In any event, I wish I knew the cause and the implication for inflation of soaring gold prices, but I don't. It could just be rampant speculation, and/or heavy buying on the part of central banks trying to diversify their exposure to fiat currencies. In the latter case, I would be quick to add that central banks have a poor record when it comes to predicting inflation.