M2, GDP, and interest rate update

A quick update on M2, GDP, and interest rates: 

There is still a "surplus" of M2 money, but it is shrinking every month. Higher interest rates have boosted the demand for money, in effect neutralizing the declining M2 surplus. We know this because all indicators point to a significant decline in inflation, especially when measured at the margin (year over year growth rates can be very misleading when important changes in trends are occurring). High interest rates discourage borrowing (banks expand the money supply by lending), encourage saving and discourage spending (holding onto all that M2 keeps it from getting spent).

Inflation is not driving interest rates higher—the Fed is. Real interest rates on TIPS have surged to levels not seen since before the Great Recession. This is a sign of monetary tightness, as is the recent weakness in gold prices, the strength of the dollar, and well-grounded inflation expectations. It may also be a sign that the market has become more confident about the outlook for the economy. There's one thing that has the market worried, however, and that's the risk that the Fed will keep on pushing rates higher than they need to be. 

The BEA today released revised GDP statistics going back many years. Real (inflation-adjusted) GDP is now measured in 2017 dollars (before it was 2012 dollars), and the revisions show it has been growing a bit faster since 2009 than we thought (before it was 2.1% per year, now it's 2.2% per year). The much-feared recession (I've lost track of the many recession forecasts that have fallen by the wayside over the course of this year) has yet to appear, and I still see no signs that it is imminent or likely in the near future.

Chart #1

As Chart #1 shows, M2 has fallen by almost 4% since its peak in the summer of last year. The "gap" between M2 and its long-term trend growth of 6% per year since 1995 has now shrunk by half and looks set to continue shrinking. When M2 first surged there was no increase in inflation because the demand for money in the first phase of the Covid lockdowns was intense—fear was rampant, and it was difficult to spend all the money that was being showered on the public in the hopes it would forestall a depression. But as the economy began to open in early 2021, the demand for money began to fall and that fueled a surge in inflation—demand for goods and services outstripped the supply. The Fed failed to react to this dynamic at first, (saying inflation was just "transitory") but then began tightening in earnest in early 2022. 

Chart #2

Chart #2 is evidence that the surge in M2 was caused by excessive, debt-fueled government spending. M2 surged just as the federal deficit surged. Declining deficits removed the source of M2 growth beginning in early 2021. We are fortunate that the second surge in deficit spending, which began about a year ago, has not resulted in any increase in M2. Deficits are no longer being monetized. Thank goodness. And so far, there has been no return of Covid panic.

Chart #3

Currency in circulation comprises about 10% of M2. As Chart #3 shows, currency growth also surged in the wake of Covid, only to retreat. The excesses of the Covid era are fading.

Chart #4

Chart #4 shows the growth of real GDP (blue line) as it compares to two different trend rates of growth (green and red). From the 1960s until 2007, real GDP grew on average by about 3.1% per year. Following the Great Recession, it has only grown by about 2.2% per year. What caused such a huge change? I think it is the result of 1) excessive government regulation and spending, 2) higher tax burdens, and 3) increased social welfare spending (transfer payments). Whatever the cause, the economy has experienced sub-par growth for over two decades. Things are unlikely to improve unless we reverse the causes of sub-par growth, and that's not about to happen anytime soon.

Chart #5

Chart #5 shows the quarterly annualized rate of growth of the GDP deflator, which is the broadest and most timely indicator of inflation available. During the second quarter of this year, prices throughout the economy rose at a mere 1.7% rate, well below the Fed's professed target. Memo to Fed: pass this chart around the office!

Chart #6

Chart #6 looks at the level of 5-yr real and nominal yields, and the difference between them (green line), which is the rate of inflation the market expects to prevail over the next 5 years. Inflation expectations are well grounded, and have fallen in the past year or so—thanks to the Fed's decision to jack interest rates up. One important conclusion thus appears: interest rates are higher not because of inflation fears, but because of the Fed's actions. And the Fed's actions appear to be driven meaningfully by mistaken worries that the economy might prove to be too strong and thus inflation might remain too high. Balderdash: the economy is still experiencing sub-par growth even as inflation has plunged. Growth didn't cause inflation, deficit spending that was monetized did, and it's not happening anymore.

UPDATE (Sept. 29):

Chart #7

Chart #7 shows the 6-mo. annualized change in the Personal Consumption Deflator and its Core (ex-food and energy) version, both of which were released this morning. The former is a broader measure of inflation than the CPI, and its weightings change dynamically as the economy changes (not so with the CPI, which is why it is a flawed measure). It is up at a 2.6% annualized rate. The latter is the Fed's favorite measure of inflation, and it is up at a 3.0% rate; but on a 3-mo. annualized basis, it is up only 2.2%. Inflation is rapidly approaching the Fed's target—why can't they acknowledge this? Why is the market so nervous? 

Chart #8

Chart #8 shows credit spreads for investment grade and high-yield corporate debt, as of yesterday. By any measure, credit spreads are relatively low, and that implies a healthy economic outlook. There is no sign whatsoever here of an impending recession. This chart also directly refutes the idea—apparently embraced by our addled Fed—that economic weakness is necessary to bring inflation down. Since inflation peaked in mid-2022, investment grade spreads have fallen from 171 bps to 123 bps, and high yield spreads have fallen from 600 bps to 409 bps. Both of those declines imply a much-improved economic outlook at the same time as inflation was falling from 8-9% to less than 3%.

What the Fed is overlooking

Yesterday the FOMC decided to keep its target Fed funds rate unchanged at 5.5%. That was no surprise to the market, but the tone of Powell's press conference and meeting minutes convinced the market that rates are likely to be "higher for longer" than previously expected. Market expectations are now geared to expect one more hike before year end, and only a few cuts by the end of next year. To judge by the market's reaction, there's a bit of panic in the air—maybe this time the much-feared recession that was just around the corner most of the year will finally arrive?

It's a shame that economic growth has come to be feared rather than welcomed. We've had 2% growth for over a year now, and inflation has plunged. Growth doesn't cause inflation; too much money relative to the demand for it is what does. The Fed was late to the tightening party, but they have delivered in spades. Today's high interest rates have boosted the demand for money by enough to result in a significant decline in inflation. 

It's terribly unfortunate, but the Fed worries that they haven't done enough, and that they may have underestimated the economy's strength. This tells me that the Fed is overlooking some very important developments: 1) the fact that inflation by current measures has already fallen within range of its long-term target (see Chart #7 in this post), 2) the ongoing slowdown in the growth of private sector jobs, and 3) the emerging weakness in the housing market. 

This post focuses on the housing market, which has suffered a triple whammy of soaring home prices, soaring mortgage rates, and soaring spreads over Treasuries that has combined to crush new mortgage applications, weaken housing starts and cool builder sentiment. 

Chart #1

Chart #1 shows the nominal and real (inflation-adjusted) index of national home prices according to Case-Shiller. (Note: the June figure is actually an average of April, May, and June prices). Home prices are within inches of their all-time highs, and 15% higher, in inflation-adjusted terms, than they were at the peak of the housing market boom in 2006. 

Chart #2

revise?????

Chart #2 shows the level of 30-yr fixed rate mortgages (blue), the level of 10-yr Treasury yields (red), plus the spread between the two (green). As is widely known, 10-yr Treasuries set the bar for fixed rate mortgages. In normal times, mortgage rates tend to be about 150-175 basis points higher than Treasury yields. Today, however, they are about twice as high as that (320 bps). Treasury yields have surged from 1.5% in early 2022 to now 4.4%, and mortgage rates have exploded from 3% to now 7.25%. Since the effective rate today on all outstanding mortgages is about 3.7%, anyone refinancing or taking out a new mortgage faces the prospect of a huge increase in mortgage payments on top of housing prices that have climbed to record levels. It's enough to make nearly everyone think twice. And what they're thinking is that borrowing money today is not a pleasant experience. That is how higher interest rates increase the demand for money: it's better these days to be long money than short money—in the sense that being "long" means you own it, while being "short" means you owe it. What a change from a few years ago, when I noted repeatedly that the Fed was encouraging people to "borrow and buy."

Chart #3

Chart #3 shows an index of new mortgage applications, which are down 70% from the highs of the mid-2000s, and down over 50% from the highs of late 2020. Housing market activity has been severely impacted by higher rates, and the Fed's stance today promises no relief for the foreseeable future. This is powerful evidence of an increase in money demand.

Chart #4

Chart #4 shows a measure of housing affordability, which today is as low as it has ever been, thanks to the combination of soaring home prices and soaring mortgage rates. (I would guess that the affordability of homes in the Los Angeles area would register about 60 on this chart.) 

Chart #5

As Chart #5 shows, since early last year existing home sales activity has dropped by 36%, to levels not seen since the depths of the housing market slump in 2010. Very few want to sell, and very few are able to buy. This is evidence that the housing market is unstable. Very low turnover means that prices are not a reliable indicator of value.

Chart #6

Chart #6 compares housing starts to an index of homebuilder sentiment. Both have dropped sharply from the highs of the past few years. Since early last year, housing starts have fallen almost 30%, and homebuilder sentiment has dropped by almost 50%. Over the same period residential construction spending has dropped about 10%—with further drops very likely to come in the months ahead (residential construction spending is highly correlated to housing starts, but with a lag). 

All of this is reason enough to question the overall strength of the economy. Lurking in the background are $2 trillion annual deficits fueled by excessive and wasteful government spending, the Biden administration's recent throttling of oil exploration and drilling activity, and soaring energy prices. Very expensive energy, just like high taxes, are sure-fire ways of throttling economic growth. Too much government spending is almost guaranteed to sap the economy's strength.

Conclusion: The Fed is highly unlikely to deliver on its "higher for longer" interest rate target for much longer. In coming months events are likely to transpire which will convince both the Fed and the market that inflation is lower and the economy is weaker than commonly thought. And that interest rates need to come down.

Still no boom, no bust

Back in July I ran a post titled "No boom, no bust." Things haven't changed much since then: inflation has come back down to earth, and the economy continues to grow, albeit slowly. Stocks are up a bit, the Fed tightened once, credit spreads have tightened a bit, and the market continues to worry that another Fed tightening might be the kiss of death for the economy. 

Chart #1

Chart #1 compares the level of the S&P 500 to the level of the Vix "fear" index. The two tend to move in opposite directions: rising fear levels result in lower stock prices, and vice versa. The Vix index is back down to pre-Covid levels, and stocks have been rising—though not yet to new highs. 

Chart #2

Chart #2 shows Bloomberg's Financial Conditions Index, a reliable measure of the underlying health of the financial markets and thus a forward-looking indicator of the health of the economy. Conditions are about average these days, so it's reasonable to expect the economy will continue to grow, albeit slowly (~2%). 

Chart #3

Chart #3 compares industrial production levels in the U.S. and the Eurozone. There has been very little progress in the level of industrial production since 2007, although the U.S. economy has been somewhat more dynamic than the Eurozone economy by this measure. Still, nobody's posting gangbuster numbers.

Chart #4

Chart #4 shows U.S. manufacturing production, a subset of overall industrial production. Here again we see very little improvement in recent decades. Ho-hum. But neither do we see any deterioration.

Chart #5

Chart #5 shows two measures of producer price inflation at the final demand level. This captures inflation at an earlier stage of inflation pipeline than the CPI. By either measure, inflation has fallen to less than 2%. The Fed's done. The CPI won't be far behind, except for the fact that energy prices have spiked of late—through no fault of the Fed's. Biden's Green agenda is at work here, as well as fallout from the Ukraine-Russia war.

Chart #6

Chart #6 shows two broader measures of inflation at the wholesale level (as of August). Here again we see inflation back down to where it should be: 2% or less. 

Chart #7

Chart #7 shows the 6-month annualized rate of change of the CPI compared to the CPI less shelter costs. As I and many others have been pointing out for the past several months, shelter costs have been artificially inflated as a result of the BLS using backward-looking statistics related to housing prices. 

Chart #8

Chart #9

The major component of shelter costs used in the CPI comes from what is called Owner's Equivalent Rent. As Chart #9 shows, OER is driven primarily by housing prices 18 months in the past. The chart shifts OER to the left by 18 months to correct for this. Here we see the peak in housing price inflation corresponding to the peak in OER. Since housing prices peaked over a year ago, OER is now beginning to decelerate. That deceleration is showing up very clearly in Chart #8, which looks at changes in the level of OER over 1- and 3-month annualized rates. What this means is the OER is going be contributing meaningfully to lower rates of CPI inflation in coming months. 

The FOMC meets next week, and I see no reason for them to raise rates yet again. The big question is when they will begin to lower rates. Today the market is betting on a 30% chance of another rate hike at the November meeting, with rate cuts not likely until mid-2024.

It's important to note (again) that Fed tightening this time around is fundamentally different from tightening cycles in the past. The main difference this time is that the Fed is not draining reserves from the banking system. Reserves are still plentiful at over $3 trillion. That's a huge deal. Chart #2 makes the point another way: there is no shortage of liquidity in the financial markets, unlike during periods leading up to recessions in the past. The only thing that is "disturbing" the economy this time around is that short-term interest rates are relatively high. That doesn't necessarily pose a threat to the economy. It simply makes it more attractive for people to hold money—that is, higher rates increase the public's demand for money, and that in turn neutralizes the amount of "excess" M2 that is still circulating. See this post from late August for a more detailed explanation.