M2 update: Ok for now, but the Fed should ease

This blog has the distinction of periodically tracking and analyzing the M2 measure of money supply for almost 2 decades. Unlike most other analysts, I focus not just on the supply of money but also on the demand for money. For background, see this post from October 2020 in which I noted rapid growth in M2 but was not alarmed given the huge increase in money demand at the time.

The key to understanding the relationship between money and inflation is to not lose sight of the demand for money. Milton Friedman famously taught us that inflation happens only when the supply of money exceeds the demand for it. When the M2 money supply accelerated in 2009 and 2020-21, it did not immediately ignite inflation because the demand for money also accelerated—with Covid shutdowns it was quite difficult to spend money. But when the demand for money began to decline in early 2021, the money that had been stored in bank deposits and under mattresses began to be released into the economy, and this was the fuel for rising inflation in 2021 and into early 2022. By mid-2022 the Fed had responded to rising inflation by raising interest rates and slowing the growth of M2, thus bringing money supply and demand slowly back into balance. This gave me the confidence in the summer of 2022 to predict that the peak of inflation was now past and it would begin to decline. Since then I have continued to believe that inflation would remain low, given that although the demand for money was declining to pre-Covid levels, M2 growth remained very slow.

The charts that follow are updated with the latest data. Fortunately, there has been no significant change in monetary conditions, and that is why I continue to see inflation remaining relatively low and stable.

Chart #1

Chart #1 shows the level of the M2 money supply. From 1995 to late 2019, it grew by about 6% per year. During that same period, inflation registered about 2% per year. M2 growth then exploded in early 2020, fueled by $6 as $6 trillion of transfer payments were sent to the public to compensate for Covid-related shutdowns—money that the Fed essentially "printed" and helicopter-dropped into the economy. M2 began to slow in mid-2022 as the Fed began to raise interest rates. Today M2 is only $1.3 trillion above where it might have been had we not suffered from the government's disastrous Covid policies and the Fed's failure to react to huge swings in money demand in a timely fashion.

Chart #2

Chart #2 shows the 6-mo. annualized rate of change in the M2 money supply. Growth has been below 6% since April '22, almost 4 years. Over the past year, M2 has grown only 4.9%. Milton Friedman would be pleased.

Chart #3

Chart #3 shows the the ratio of M2 to nominal GDP, which is arguably a good proxy for money demand. Think of it as the percentage of our annual income that we collectively prefer to hold in the form of readily spendable money (currency, checking accounts, time deposits, CDs, and money market funds). Money demand appears to have returned just about to where it was before the Covid era. Both M2 growth and money demand have now returned to "normal" levels, and they are roughly in balance. This is very good.

Chart #4

But, you object, inflation is still above the Fed's 2% target. Yes, the Core Personal Consumption Deflator is up 3.1% in the year ending January '26, and the overall Personal Consumption Deflator is up 2.7%. But the CPI is up only 2.4% as of February, and the CPI less shelter is up only 2.2%. We're not talking about a meaningful overshoot. Of course, I would prefer to see 0% inflation, but what we have today is the next best thing.

Chart #4 shows the 3 major components of the PCE deflator. Note that durable goods prices today are lower than they were in late 2022, and non-durable goods prices have only increased 2% since mid-2022 (which works out to an annualized rate of only 0.6%). The major source of inflation in recent years comes from service sector prices, which are heavily influenced by shelter costs and wages. As I've shown numerous times in recent years, the government has been systematically over-estimating shelter costs. The PCE deflator doesn't have an ex-shelter version like the CPI does; if it did it would likely show inflation being much closer to 2% than to 3%.

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So what about the Iran war and soaring fuel prices? Yesterday I paid $7.09 per gallon to fill my tank. Yikes! Surely this will upset the inflation apple cart, no?

Most likely we'll see an upward bump in the official inflation numbers in the months ahead, given the recent increase in energy prices. But that's not how inflation works. With the economy on a strict diet of 5-6% money growth, there is no reason to expect that the entire price level will jump higher. Energy prices will go up, but other prices will come down. Already we're seeing non-energy commodity prices softening. And with the recent uptick in 30-yr mortgage rates and the surge in new home sales for sale, real estate prices are more likely to decline than to rise. 

Most important, however, is this: wartime uncertainties are very likely to spark an increase in money demand. Without a corresponding increase in money supply—and especially since the Fed shows no willingness to lower interest rates—the economy will soon feel starved for money. That's deflationary. We won't see deflation for several months, but don't be surprised if it happens later this year.

My advice to the Fed would be to relax monetary policy soon in anticipation of a meaningful increase in money demand. But sadly, the Fed is usually reactive and rarely—if ever—proactive.