M2 and Nominal GDP Update: still growing rapidly

I am fascinated by the fact that these days hardly anyone is talking about the very rapid growth in both M2 and nominal GDP. Both suggest that inflation is alive and well, and very likely to continue.

The big news this week was that the Fed is doing its best to avoid an aggressive tightening of monetary policy. Which makes it strange that the market sold off on the news that the Fed plans to accelerate (ever so slightly) its tapering of asset purchases while also planning to begin to lift short-term interest rates (in gingerly fashion) in about two months. As I've been arguing for awhile, the threat of tight money is a problem that still lies well into the future; it's certainly something to worry about, but not for now. Monetary policy today is still extremely accommodative, and almost certainly the culprit behind our inflation problem. 

Today the Fed said that they plan to start raising short-term rates in early March. The bond market expects the Fed will ratchet up rates by 25 bps at a time until reaching a "terminal rate" for their Fed funds target of about 2.5% in about 3-4 years' time. In my book, that hardly rates as tight money. Actual tightening involves a significant rise in the real Fed funds rate (e.g., to at least 3%). It also involves a flattening or inversion of the Treasury yield curve, which is still moderately steep. We're not even close to those conditions, and the Fed has virtually assured us they are unlikely to slam on the monetary brakes anytime soon. 

Most observers these days argue that inflation is the result of too much demand (fueled by government stimulus payments) and not enough supply (e.g., Covid-related supply bottlenecks). Hardly anyone talks about the unprecedentedly rapid growth of money, aside from me and a handful of other economists (e.g., Steve Hanke, John Cochrane, Ed Yardeni, and Brian Wesbury). Moreover, I'd wager that the great majority of the population doesn't understand that supply and demand shocks can only affect the prices of some goods and services, but not the overall price level. If all, or nearly all prices rise, that is a clear-cut sign of an excess of money relative to the demand for it. That is how inflation works.

There are other reasons to think the recent stock market selloff is overdone, if not premature. Credit spreads—which measure actual stresses in the economy—are still relatively low. Swap spreads—which are a good indicator of liquidity—are very low. Together, these spreads tell us that liquidity is abundant, economic stresses are low, and the outlook for corporate profits—and by inference the economy—is healthy. Ironically, the main problem for now is that the Fed is not prepared—yet—to do anything that might slow the rate of inflation or threaten the economy for the foreseeable future. They'd rather lay the blame for inflation on Congress than take the heat themselves. And don't forget that Powell is up for renomination soon. 

Chart #1

Chart #1 shows the growth of currency in circulation, which represents about 10% of the M2 measure of money. After surging at 20% annualized rates in Q2/20, the growth of currency has slowed to about a 5% annualized rate, which is somewhat slower than its long-term trend growth of about 6.6% per year. As I've explained before, the supply of currency is always equal to the demand for currency, which means that currency growth is not contributing to our recent inflation problem. Currency growth was quite rapid last year because the demand for currency was very strong, fueled by all the uncertainties of the Covid threat. But the fact that currency growth has since slowed significantly since then suggests that precautionary demand has faded: this is arguably a good leading indicator that the demand for money balances in checking accounts and bank savings account is also softening or beginning to soften. In the absence of any slowing in the growth of M2, any reduction in the demand for money in the system is precisely what fuels a rise in the general price level. If the Fed does nothing in response, such as raising short-term interest rates and draining reserves from the banking system, inflation is very likely to continue

Chart #2

Chart #2 shows the growth of the M2 monetary aggregate. Here again we see explosive growth in Q2/20 and a subsequently slower—but still quite rapid—rate of growth which continues to this day. For the past year or so, M2 growth has been averaging about 12-13%. That is twice as fast as its long-term trend rate of growth, and it shows no sign of slowing, even though the Fed has been tapering its purchases of securities (to be fair, tapering does nothing to reduce inflation). This is good evidence that M2 is growing because banks are lending money by the bushel, which is the only way the money supply can expand. The public's apparent demand for loans is thus strong, and that is symptomatic of a decline in the demand for money. 

 

Chart #3

Chart #3 shows the growth of M2 less currency, which is equivalent to all the money that has been supplied by the banking system via lending operations. It's important to remember that the Fed cannot create money directly; the Fed only has the power to limit bank lending by limiting bank reserves, and to influence the public's demand for money via increasing or decreasing the overnight lending rate. Again we see the same pattern: explosive growth of M2 in Q2/20 followed by a slower (but still rapid) 13-14% pace since then that shows no signs of slowing (as of the recently-released data for December '21). The growth of money on deposit in our banks is growing at more than twice its historical rate, and that has been the case for the past 18 months. Needless to say, this is nothing short of extraordinary. And it is the stuff of which inflation is made.

Chart #4

Chart #4 shows that the M2 money supply is now equal to about 90% of the economy's nominal GDP. Since the latter is roughly equivalent to national income, this means that the average person or entity today is holding almost one year's worth of his annual income in a bank deposit of some sort. This is a level that was only exceeded in Q2/20, at the height of the Covid panic, and it is far above any level we have seen for many decades. People have effectively stockpiled an unprecedented amount of money in bank accounts and savings accounts that pay almost no interest! On its face, this would suggest that the demand for money (non-interest bearing money) has been intense. But will that demand remain strong? The fact that inflation has surged in the past year is good evidence that money demand is already declining: people are trying to get rid of unwanted money by spending it, and that is what is driving higher inflation.

Chart #5

Real GDP grew by a very healthy 5.5% in 2021, but about 70% of that growth came from inventory rebuilding—so we are very unlikely to see another such number. The general price level rose by 5.9%, which means that nominal GDP grew by a whopping 11.7%, which is not surprising since the M2 money supply rose by 13.1%. As Chart #5 shows, both M2 and nominal GDP have a strong tendency to grow by about the same rate over longer periods. When they diverge from this trend it's due to a change in the public's desire for money balances. Referring back to Chart #4, we see that money demand grew by about 1.6% last year, but most of that increase happened in Q1/21 when Covid uncertainty was still raging. Money demand has been steady for the past 9 months. If M2 continues to grow at a 13% annual rate, as it has for the past year, then nominal GDP growth is very likely to continue grow at double-digit rates. And since the economy is very unlikely to sustain a 5% growth rate for much longer, inflation is going to be at least 7-10% for as long as M2 growth remains at current levels. 

An important note: it is going to be many months before the Fed adopts policies (e.g., draining reserves and lifting the Fed funds rate to a level at least equal to inflation) that will slow the growth of money by increasing the public's desire to hold money. Banks have been the source of the explosion in M2 growth, and the only thing that will change this for the better are policies designed to make holding money more attractive; banks need to be less willing to lend to the public and the public needs to be less willing to borrow. Much higher short-term interest rates are thus the cure for our inflation blues. But we won't be seeing them for a long time.

Chart #6

Chart #6 shows how increases in housing prices tend to lead inflation by about 18 months. Housing prices have been rising at a 15-20% annual rate for the past year or so, and that is very likely to add substantially to consumer price inflation for at least the next year. Owner's equivalent rent comprises about 25% of the CPI.

Chart #7

Chart #7 compares the real yield on the Fed funds rate (blue line) to the slope of the Treasury yield curve (red line). Note that every recession (gray bars), with the exception of the last one, has been preceded by a significant increase in real yields and a flattening or inversion of the yield curve. Both of those conditions are highly indicative of "tight money." We won't see anything like that until at least next year, given the Fed's obvious desire to avoid shocking the bond market and/or risking another recession.

Chart #8

Chart #8 compares the growth of nominal GDP (blue line) with two different long-term trend lines. (Note that the chart uses a semi-log y-axis, which shows constant rates of growth as straight lines.) The economy grew by 3.1% per year[ on average from 1966 through 2007. Since 2009, it has grown by about 2.1% on average. Unless policies become more growth friendly, we are thus unlikely to see GDP exceed 2% on a sustained basis. That again highlights the fact that 13% M2 growth, if it continues, will likely result in sustained inflation of 10% or more this year.  

All eyes should be glued to the growth of M2, which is released around the end of the third week of every month.

Chart #9

Chart #9 compares the growth of the personal consumption deflators for services and durable goods. Of interest is the explosive growth in durable goods prices. 

Chart #10

Chart #10 shows the behavior of the three main components of the PCE deflator since 1995. I chose that date because it marks the debut of China as a major source of cheap durable goods for the world. As the chart shows, all prices are now on the rise, with durables leading the way after decades of falling, and services prices (which are strongly correlated to wage and salary growth) now beginning to accelerate. 

This is the very definition of true inflation: when nearly all prices rise, not just a few.

Chart #11

Chart #12

Finally, Charts #11 and #12 recap the status of swap and credit spreads. They tell us that liquidity is abundant nearly everywhere, and that the outlook for corporate profits is healthy. We are very unlikely to be on the cusp of another recession. That's the good news.

The bad news is that sustained inflation of 7-10% will cause significant problems in the months and years to come. Inflation will be a boon to federal government finances, but it will be the bane of the rest of the economy, because inflation is essentially a hidden tax that all holders of money end up paying the government. Over time that will work to sap the economy of its energy, resulting in slower economic growth. 

The bond market is wrong about inflation

I've been making this point for quite some time now, so the purpose of this post is mainly to update the argument with the latest news. I would also like to recommend an article by Thomas Sargent and William Silber that appeared in today's WSJ: "The Market Is Too Serene About Inflation." They make essentially the same points I do, but they nicely add some historical context. In the 1980s, it took the bond market a long time to realize that the Fed had successfully brought inflation down from double- to single-digits. What we're seeing today is similar, only opposite: it's going to take the bond market a long time to realize that the Fed has allowed inflation to increase significantly. 

And by the way, I was an avid student of inflation and the bond market back in those crazy days of the early- to mid-1980s. I worked for John Rutledge at his consulting firm (the Claremont Economics Institute) during that time, and we were almost alone in our conviction that the combination of Volcker's monetary policy and Reagan's tax cuts would result in a huge decline in inflation and interest rates. It took a few years, but we were finally proven right. So I'm not totally surprised to see the bond market making another mistake, even if the circumstances are quite different this time around.

Chart #1

Chart #1 compares the yield on 10-yr Treasuries to the year over year change in the Consumer Price Index. We've never seen such a huge difference between the two, and I for one never thought something like this would or could ever happen. Where are the bond market vigilantes when we need them? Those vigilantes are supposed to ensure that interest rates are nearly always as high or higher than the rate of inflation. That's certainly NOT the case today.

Chart #2

As Chart #2 shows, oil prices have nothing to do with today's inflation problem. Ex-energy inflation is off the charts. And to judge by the huge difference between today's inflation and today's interest rates, the bond market has only just begun to be concerned. 

Chart #3

Chart #3 shows the ex-post real yield on 10-yr Treasuries (i.e., the difference between nominal yields and the rate of inflation according to the CPI). Real yields today are lower than at any time in my lifetime. The last time we saw anything like this was in the inflationary 1970s. 

This is crucially important: when real yields are hugely negative, as they are today, this provides fuel to the inflationary fires, because the returns on cash and cash equivalents are so miserable that it destroys the demand to hold cash. And as I've explained in many prior posts, it's the weak and falling demand for money that is driving today's inflation. Inflation won't end until the Fed corrects this problem, and unfortunately, it doesn't look like they will do that anytime soon. Just today, Powell promised that although the Fed is prepared to raise rates, they will be careful to do so in a fashion that won't rock the markets or the economy. Sorry, I don't think the bond market will take a lot of consolation from this sentiment. 

Chart #4

As Chart #4 shows, there is about an 18-month lag between rising rents (about 25% of the CPI is based on what homeowners think they would be paying to rent the house they own) and rising inflation. Given that rents are up only a little less than 4% in the past year, while housing prices nationwide are up about 20%, there is likely a lot of rent inflation that has yet to find its way into the CPI over the next year. 

Chart #5

And it's not just rent that is going up, as Chart #5 shows. Industrial commodity prices (hides, tallow, copper scrap, lead scrap, steel scrap, zinc, tin, burlap, cotton, print cloth, wool tops, rosin, and rubber) are up over 25% in the past 12 months, and they now stand at a new, all-time high.

Chart #6

As Chart #6 shows, despite all the evidence of higher inflation, not to mention the runaway growth of the M2 money supply, as I illustrated in Chart #3 of last week's post, the bond market expects that the CPI will rise on average only about 2.8% per year for the next 5 years.

Keep your seatbelts fashioned, the next few years could be a wild ride.

COVID-19 recommended reading: This article comes from a leading Israeli virologist. The short summary: 1) respiratory viruses cannot be defeated, 2) mass testing is ineffective, 3) natural immunity trumps vaccines, 4) those vaccinated can be and are infectious, 5) Covid death risk is highly concentrated among the elderly and those with several co-morbidities, 6) vaccine side effects are not insignificant, 7) children and young adults should never have been isolated, and 8) masks and lockdowns are ineffective and counter-productive.

I can't pass up the opportunity to repeat my prediction of April/May 2020: "The shutdown of the US economy will prove to be the most expensive self-inflicted injury in the history of mankind.™"

UPDATE: links to articles should be fixed now.

Gold and the Fed

In response to a reader's comment regarding why gold prices these days are falling while inflation is rising, I offer two charts which may help. 

The bottom line is that gold prices do not react to changes in inflation, they anticipate changes in inflation. Markets are constantly trying to predict what will happen, oftentimes well in advance of the actual event. This is as it should be, of course. Otherwise it would be too easy.

Chart #1

Chart #1 compares gold prices to the real yield on 5-yr TIPS (inverted). The inverse fit between gold and TIPS yields is pretty impressive, but I caution that this fit does not apply so well to the years prior to what is shown in this chart. My interpretation of the chart begins with the observation that real yields as reflected in 5-yr TIPS are a proxy for how accommodative or tight the market expects the Fed to be in coming years. An accommodative Fed is one that will tend to push real yields lower (as happened during the period 2007 through 2011). A tight Fed does the opposite: it pushes real yields higher (as happened from 2012 through 2015). When the Fed is expected to be easy, gold prices rise in the expectation that an easy Fed today will deliver higher inflation tomorrow, and vice versa. Currently, real yields are beginning to rise from very low levels, and the gold market is weak in the expectation that a tighter Fed will deliver lower inflation in the future.

Chart #2

Chart #2 covers a shorter time frame (and I repeat my caution that these relationships do not always hold over every time period). The way to interpret the blue line is that it is a proxy for what the market expects the Fed funds rate to be in three years' time. The Fed was expected to be super-easy in late 2020 and early 2021, and that is why 3-yr forward interest rate expectations were super-low. As with Chart #1, the story here is that when the market expects the Fed to be in a tightening mode (as has been the case for the past year or so), then gold prices tend to decline because the market expects inflation risk to decline in the future. Once again, the gold market is anticipating changes in inflation conditions, not reacting to changing inflation. 

Interestingly, a strict interpretation of Chart #2 would lead one to surmise that gold prices are overdue for a decline. It will be interesting to see if this actually happens.