SPTS - M2: The Smoking Gun Of Inflation

Summary

• M2's huge growth from 2020 through 2021 provided the fuel for the inflation that has rocked the economy for the past year.
• Inflation pressures peaked almost a year ago, and headline inflation will almost certainly continue to subside.
• The Fed doesn't need to do more than they already have. The lower-inflation wheels have been set in motion.

Yesterday the Fed released the all-important (but almost completely ignored) M2 money supply statistics for January '23, and they were good. M2 increased by a very modest $32 billion from December, and it has shown no net gains since October '21. Year-over-year M2 growth is -1.7%, and 6-mo annualized growth is -3.4%.

M2's huge growth from 2020 through 2021 provided the fuel for the inflation that has rocked the economy for the past year, and it's great news that it's fading away. The growth of M2, by over $6 trillion in two years, was the result of the monetization of roughly $6 trillion of Treasury debt issued to fund a tsunami of federal transfer payments in that same period. Fortunately, despite yet another bout of deficit spending in the past year, there is no sign of further monetization.

It is still mind-boggling to me that the unprecedented growth of M2 has almost completely escaped the public's notice. Most surprising of all: how in the world could the Fed not see it? Why was there only a handful of economists who commented on it, as I noted a year ago ? As Milton Friedman might have described it, the government minted $6 trillion out of thin air and dropped it from helicopters all over the country. How could that not have resulted in higher prices?

In any event, here we are; the flood of funny money is receding. That's why there is now plenty of light at the end of the inflation tunnel.

Chart #1 is the main attraction. The M2 money supply exploded from $15.5 trillion in February '20 to $21.5 trillion in January '22. Since then, M2 growth has turned negative, and today M2 is only $3.4 trillion above where it might have been in the absence of the Fed's "helicopter drop." The gap is closing, and the money printing presses have been shut down. Inflation pressures peaked almost a year ago, and headline inflation will almost certainly continue to subside.

Chart #2 shows the 6-mo. annualized growth rate of M2, which is now -3.4%, down sharply from a high of over 40% in August of 2020. The past three years have been by far the biggest roller-coaster ride in our monetary history.

Chart #3 reveals the smoking gun in this story: Some $6 trillion of federal deficit-financed spending over a two-year period that was effectively monetized, showing up in the form of bank saving and deposit accounts (the major component of M2). At first this was fine, because the public was not willing or able to spend it—the demand for money was intense. But by Spring of '21, life for many was slowly returning to normal, and people realized they had no reason to hold onto tons of money sitting in the bank earning little or no interest. Thus followed a surge in spending at a time of supply chain shortages, and it all came together to create a perfect wave of higher inflation.

Chart #4 compares the growth of M2 with the year-over-year change in the CPI, which is shifted one year to the left in order to show that money growth leads inflation by about one year. This chart further suggests that the year-over-year change in the CPI will gradually fall to the Fed's 2% target over the course of this year, thanks to the huge deceleration in M2 growth over the past year.

Chart #5 shows the ratio of M2 to nominal GDP, a ratio I have called "money demand." Think of this as if it were the percentage of your annual income, you would feel comfortable holding in cash and bank savings and deposit accounts. Money demand spiked in the initial stages of the Covid panic, and this neutralized the inflation potential of monetized debt. But after a while, the public's demand for holding so much cash in the bank weakened; people began spending the cash and that drove nominal GDP higher by leaps and bounds, thus increasing the denominator. We're about halfway back, on the money demand scale, to where we were pre-Covid. Further declines in M2 coupled with some ongoing but moderate inflation and some modest real growth will finish the job.

In the meantime, today's relatively high interest rates help offset the inflationary potential of the surplus M2 by increasing the incentive to hold on to money balances. Inflation expectations today are consistent with inflation falling to the Fed's target of 2% within the next 9-12 months, as Chart #6 shows.

The Fed doesn't need to do more than they already have. The lower-inflation wheels have been set in motion.

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