M2 still has plenty of inflation potential

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M2 money supply growth has slowed in recent months (thank goodness!) and today’s FOMC announcement was less aggressive than the market feared. Stocks jumped in a sigh of relief. As I said last February, Fed tightening is not a near-term threat. Either way, I still think the Fed and the bond market are behind the curve. And as I point out in this post, the level of M2 still abounds with inflationary potential.

Chart #1

M2 growth rate

Chart #1 shows the 6-month annualized growth of M2 money supply at the end of the first quarter. After posting double-digit growth rates over the past two years – a stunning development unprecedented in US history – M2 growth has slowed to an annual rate of 8% over the past six last months and 6.2% over the last three months. For reference, M2 growth has averaged around 6% per year from 1995 to early 2020. So, with growth rates back to “normal”, is that any cause for celebration? Barely. If growth hadn’t slowed, it would have been very worrying; As it stands, cumulative M2 growth is still breathtaking and very likely to fuel uncomfortably high inflation for the foreseeable future.

Graph #2


Chart 2 shows the level of M2 against its long-term trend growth rate of 6% per year, using a logarithmic y-axis, so that a straight line on the chart represents a rate constant growth. This chart, which I have been presenting for many months, tells an amazing story that is still almost completely ignored by most economic and financial market watchers. Of the many articles on the topic of inflation, you’ll find that less than one in ten even mention the money supply. To my knowledge, there are only a handful of reputable economists who see things the way I do: Steve Hanke, John Cochrane, Brian Wesbury, Ed Yardeni and Bill Dudley.

A few things to note in the chart: M2 is now about $4.8 trillion higher than it would have been with continued 6% annual growth. In other words, M2 is now about 28% above trend, which is more than four years of normal growth. If you were to ask any monetarist in 1995 about the consequences of such a growth rate of M2, he would undoubtedly have replied that your question was too absurd to consider. Regardless, this chart provides all the evidence needed to explain why inflation over the past year has far exceeded expectations— and it is likely to continue to do so.

Graph #3

Federal expenditures

Graph #4

Federal budget surplus/deficit

Arguably, the surge in 2020 and the recent slowdown in M2 growth has a lot to do with the huge swings in government spending, as shown in Chart 3. The spending spike was purely for Covid relief and “stimulus,” and it was entirely funded by the issuance of new debt, most of which was effectively monetized by the banking system. Fortunately, the government is no longer flooding the economy with relief checks, and Biden’s absurd “Build Back Better” initiative is dead, so much more monetization is unlikely. Meanwhile, tax revenues are skyrocketing: Federal revenues for the past 12 months are up 27% from the prior year period, with the result that the deficit has collapsed (Chart #4). The rolling 12-month federal deficit was $1.04 trillion just before Covid; it peaked at $4.1 trillion a year ago and has since fallen to $1.74 trillion. It’s good that the spending and printing frenzy has abated, but the legacy of debt and monetary expansion is still with us.

Graph #5

Currency request

Chart 5 shows the demand for M2, which is technically called the inverse of the velocity of M2. (See this article from last January for a more detailed explanation.) The demand for money (M2/GDP) is a decent approximation of the percentage of an average person’s annual income that they want to hold in the form of cash, checks and savings accounts (which together comprise M2, the sum of all available money). For many years, the country’s currency holdings and bank deposits accounted for 55-60% of annual income. However, today, they are at 90%. Currency demand typically increases during turbulent times, and this was quite evident following the Great Recession of 2007-2009. This was even more the case following the disastrous Covid lockdowns. It is natural for people to want to hoard money in times of great uncertainty.

But now that things are back to normal and the economy has largely recovered from the disastrous Covid lockdowns and restrictions, we are likely to see a drop in demand for money. And indeed, there has already been a decline of around 4% since the initial surge in Q2/21. At the margin, people no longer wish to hold so much money, so they try to reduce their monetary balances, and this is what is fueling the resurgence in consumer demand. For more details, see my article from last year: “Argentina Inflation Lessons for the United States”

There are two ways for M2/GDP to decline: 1) slower M2 growth and/or 2) faster nominal GDP growth, which almost certainly leads to higher inflation (because nominal GDP has two components: real growth and inflation, and real growth is unlikely to increase by more than 2 or 3% per year). If the Fed stays behind the curve (ie not raising rates enough), then higher inflation will help reduce the M2/GDP ratio.

Today the FOMC announced plans to reduce its balance sheet starting next month, but they are not very aggressive and will be done mainly by not reinvesting maturing securities. Outright sales of securities, when they occur, will not be large and should be easily digested by the bond market. The Fed also announced a 50 basis point hike in short-term rates (the overnight funds rate is now 1%) and plans to hike rates in 25 and 50 basis point increments cautiously. . The bond market currently expects the funds rate to peak around 3¼ – 3½% in about a year. All in all, the rate hikes will be quite modest, as will the reduction in the Fed’s balance sheet. Will this do the trick? We’ll have to wait and see, but the Fed is still a long way from taking aggressive action to curb M2 growth and/or support money demand.

Interesting mathematical exercise: suppose M2 continues to grow by 6% per year, the public reduces its monetary balances to the pre-Covid level of 70% of GDP over the next three years and real GDP increases by 2% per year . What would be the annualized inflation rate for the next three years? Answer: about 10%. This gives you an idea of ​​the inflationary potential of the current level and growth rate of M2.

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Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.

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