M2 – Economist Writing Every Day

The last post where I attempted a macro prescription was in April 2022, when I said the Fed was still under-reacting to inflation. That turned out right; since then the Fed has raised rates a full 500 basis points (5 percentage points) to fight inflation. So I’ll try my luck again here.

Headline annual CPI inflation has fallen from its high of 9% at the peak last year to 3.7% today. Core PCE, the measure more closely watched by the Fed, is at a similar 3.9%. Way better than last year, but still well above the Fed’s target of 2%. Are these set to fall to 2% on the current policy path, or does the Fed still need to do more?

The Fed’s own projections suggest one more rate hike this year, followed by cuts next year. They expect inflation to remain a bit elevated next year (2.5%), and that it will take until 2026 to get all the way back to 2.0%. They expect steady GDP growth with no recession.

What do market-based indicators say? The yield curve is still inverted (usually a signal of recession), though long rates are rising rapidly. The TIPS spread suggests an average inflation rate of 2.18% of the next 5 years, indicating a belief the Fed will get inflation under control fairly quickly. Markets suggest the Fed might not raise rates any more this year, and that if they do it will only be once. All this suggests that the Fed is doing fine, and that a potential recession is a bigger worry than inflation.

Some of my other favorite indicators muddy this picture. The NGDP gap suggests things are running way too hot:

M2 shrank in the last month of data, but has mostly leveled off since May, whereas a year ago it seemed like it could be in for a major drop. I wonder if the Fed’s intervention to stop a banking crisis in the Spring caused this. Judging by the Fed’s balance sheet, their buying in March undid 6 months of tightening, and I think that underestimates its impact (banks will behave more aggressively knowing they could bring their long term Treasuries to the Fed at par, but for the most part they won’t have to actually take the Fed up on the offer).

The level of M2 is still well above its pre-Covid trend:

Before I started looking at all this data, I was getting worried about a recession. Financial markets are down, high rates might start causing more things to break, the UAW strike drags on, student loan repayments are starting, one government shutdown was averted but another one in November seems likely. After looking at the data though, I think inflation is still the bigger worry. People think that monetary policy is tight because interest rates have risen rapidly, but interest rates alone don’t tell you the stance of policy.

I’ll repeat the exercise with the Bernanke version of the Taylor Rule I did in April 2022. Back then, the Fed Funds rate was under 0.5% when the Taylor Rule suggested it should be at 9%- so policy was way too loose. Today, the Taylor Rule (using core PCE and the Fed’s estimate of the output gap) suggests:

3.9% + 0.5*(2.1%-1.8%) + 0.5%*(3.9%-2%) + 2% = 7%

This suggests the Fed is still over 1.5% below where they need to be. Much better than being 9% below like last April, but not good. The Taylor rule isn’t perfect- among other issues it is backward-looking- but it tends to be at least directionally right and I think that’s the case here. Monetary policy is still too easy. Fiscal policy is still way too easy. If current policy continues and we don’t get huge supply shocks, I think a mild “inflationary boom” is more likely than either stagflation or a deflationary recession.

I think so, though the path back to 2% is a long one. Two months ago I wrote that “the Fed is still under-reacting to inflation“. We’ve had an eventful two months since; last Friday the BLS announced CPI prices rose 1% just in May, and that:

The all items index increased 8.6 percent for the 12 months ending May, the largest 12-month increase since the period ending December 1981

Then this Wednesday the Fed announced they were raising interest rates by 0.75%, the biggest increase since 1994, despite having said after their last meeting that they weren’t considering increases above 0.5%. I don’t like their communications strategy, but I do like their actions this month. This change in the Fed’s stance is one reason I think we’re at or near the peak.

Its not just what the Fed did this week, its the change in their plans going forward. As of April, the Fed said the Fed Funds rate would be 1.75% in December, and markets thought it would be 2.5%. But now the Fed and markets both project 3.5% rates in December.

The other reason I’m optimistic is that the days of rapid money supply growth continue to get further behind us. From March to May 2020, the M2 and M3 supply exploded, growing at the fastest pace in at least 40 years:

Rapid inflation began about 12 months later. But the rate of money supply growth peaked in February 2021, then began a rapid decline. Based on the latest data from April 2022, money supply growth is down to 8%, a bit high but finally back to a normal range. Money supply changes famously influence prices with “long and variable lags”, so its hard to call the top precisely. But the fact that we’re now 15 months past the peak of money supply growth (and have stable monetary velocity) is encouraging. Old-fashioned money supply is the same indicator that led Lars Christiansen to predict this high inflation in April 2021 after successfully predicting low inflation post-2009 (many people got one of those calls right, but very few got both).

Stocks also entered an official bear market this week (down 20% from highs), which is both a sign of excess money no longer pumping up markets, and a cause of lower demand going forward.

Markets seem to agree with my update: 5-year breakevens have fallen from a high of 3.6% back in March down to 2.9% today, implying 2.9% average inflation over the next 5 years. Much improved, though as I said at the top the path to 2% will be a long one- think years, not months. Even the Fed expects inflation to be over 5% at the end of this year, and for it to fall only to 2.6% next year.

What am I still worried about? The Producer Price Index is still growing at 20%. The Fed is raising rates quickly now but their balance sheet is still over twice its pre-Covid level and is shrinking very slowly. The Russia-Ukraine war drags on, keeping oil and gas prices high, and we likely still have yet to see its full impact on food prices. Making good predictions is hard.

While I’m sticking my neck out, I’ll make one more prediction, though this one is easier- Dems are in for a bad time in November. A new president’s party generally does badly at his first midterm, as in 2018 and 2010. But this time the economy will be a huge drag on top of that. November is late enough that the real economy will be notably slowed by the Fed’s inflation-fighting effects, but not so late that inflation will be under control (I expect it to be lower than today but still above 5%). Markets currently predict a 75% chance that Republicans take the House and Senate in November, and if anything that seems low to me.