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The Coming Rise in Money Velocity

June 28, 2022 2 comments

As M2 money growth soared throughout the COVID and post-COVID period of direct stimulus check-writing funded by massive quantitative easing (QE), monetarism novices thought that this would not result in inflation because money velocity simultaneously collapsed. Consequently, they argued, M*V was not growing at an outrageous rate.

There was precedence for such optimism. In the Global Financial Crisis of 2008-09, money supply grew rapidly with the onset of QE and money velocity declined, never to recover. The chart below shows in a normalized fashion the rise in M, the decline in V, and the relative quiescence of MV/Q, which is of course P by definition as long as you choose your Ms, Vs, and Qs right.

A similar thing happened in this episode, so why would this be any different?

There are many reasons why these episodes are different. To name a few:

  • The absolute scale of the rise in M2 was 2.5x the rise in 2007-2010, and that’s being generous since that measures the growth in 2007-2010 starting almost 2 years before the first QE in November 2008 compared to only 15 months in the second case.
  • As I’ve written previously, QE in the first case was directed at banks; at the same time that the Federal Reserve was adding reserves it was also paying banks interest on reserves – because the point was to strengthen banks, not consumers.
  • 5y interest rates came into 2008 at 3.44%; they came into 2020 at 1.69%. Since velocity is most highly correlated to interest rates, there was less room for this factor to be a lasting downward influence on velocity (after the crisis began in 2008, 5y Treasury rates never exceeded 3% again except for a few days in 2018).
  • Bank credit growth never stopped in the 2020 crisis, while it contracted at a 5% rate in the 2008 crisis (see chart, source Board of Governors of the Fed).

The monetarist novices (you can tell they’re novices because they say things like “Friedman said velocity was constant,” which is false, or “velocity is just a plug number [true] and has no independent meaning of its own [false]”) insisted that velocity was in a permanently declining state and that there was no reason at all to expect it to ever “bounce.” After all, it bounced only slightly after the GFC; why should it do so now?

But after 2008, as I noted, interest rates bounced only briefly before declining again…with the added phenomenon that some global debt came to bear negative yields, calling into fair question whether there was in fact any natural “bottom” to velocity if interest rates are the main driver! And velocity, obediently, dripped lower as well.

There is at least one other big driver to money velocity, although it is rarely important and almost never for very long. And that is economic uncertainty, which creates a demand to carry excess cash balances (implying lower money velocity). A model driven (mainly) by rates and a measure of uncertainty has done a pretty good job at explaining velocity over time (see chart, source Enduring Investments), including explaining the collapse in velocity during the COVID crisis out-of-sample.

Now, explaining velocity is a helluva lot easier than predicting it, because it isn’t easy to predict interest rates. Nor is it easy to predict the precautionary demand for money – but at least we can count on that being somewhat mean-reverting. The latest point from the model shown above uses current data, and suggests (largely because of the rise in interest rates, but also because precautionary balances are declining) that money velocity should bounce. Not that the model predicts it will happen this week, but it should not be surprising when it does.

A rise in velocity would be a really bad thing, because the money supply is very unlikely to decline very far especially while bank credit growth continues to grow. The only reason we have been able to sustain 6% or 8% money growth for a very long time has been because we could count on velocity to keep declining with interest rates. If money growth ticks up at, say, a mere 6% while money velocity rises 5%, then nominal GDP is going to rise 11%…and most of that will be in prices.

Now, this is a very slow-moving story. I mention it now for one specific reason, and that is that we are almost certain to see a rise in velocity in Q2 when the GDP figures come out in late July. That’s because money growth for the quarter has been very slow so far. So far, the Q2 average M2 is 0.06% higher than the Q1 average. My best wild guess is that we will end up with an 0.5% annualized q/q growth rate. The Atlanta Fed GDPNow model estimates 0.25% GDP growth in Q2 (the Blue Chip Consensus is still at 3%). And if the inflation market is right, Q/Q inflation in Q2 will be about 11.7%. That’s CPI, so let’s be generous and say 9%. We don’t know all of these numbers, but we know 2/3 of all of them. Let’s use the Blue Chip consensus for GDP and assume M2 doesn’t spike next month and the price level doesn’t collapse. Then:

If that happened, the increase would be the largest quarterly jump in money velocity – absent the reactionary bounce in 2020Q3 after the 20% plunge in 2020Q2 – since 1981. And here’s the rub: because of the mathematics of declines and recoveries, that would still leave us with velocity that prior to 2020 would have been an all-time record low.

Does this matter? Not if you believe the monetarism dabblers, who will say this is a mechanical adjustment that will soon be reversed as velocity continues its long slide to oblivion. Nor will it matter to the Fed, who at best will take executive notice of the fact before ignoring it since they aren’t monetarists any longer. But for those who think that inflation comes from too much money chasing too few goods? It’s scary.

One Experiment Ends and Another Begins

June 15, 2022 5 comments

Today the Federal Reserve hiked rates 75bps, the biggest single-meeting increase since 1994. Two days ago, the markets had incorporated an expectation for 50bps. After a well-placed Wall Street Journal article that somehow everyone on the Street knew was a warning from the Fed, the markets immediately priced 75bps. I’ve never seen anything so dramatic, nor as blatantly insider. Giving weight to a “Fed mouthpiece” journalist who is assumed to have great sources at the Fed is a time-honored tradition. But I have never seen the entire market re-price with a virtual 100% certainty overnight based on a news article (especially when the last thing the Chairman had said on the subject of 75bps was fairly dismissive, not long ago). Ergo, I’m fairly confident that the article was only the public whisper. We will never know, and they like it that way.

Cynicism aside, today marked an important moment when the central bank finally admitted that inflation is higher and likely will stay higher than they previously have assumed (gone from the statement was a note that “the Committee expects inflation to return to its 2 percent objective and the labor market to remain strong”), rates will have to go higher – although they still don’t anticipate raising rates above inflation, according to the ‘dot plot’ – and that they probably can’t make this omelette without breaking some eggs.

Powell still refused to cop to the fact that this was a total policy error, and completely identifiable in real time. It’s always amazing to me that when policymakers make massive errors they always seem to think that no one saw the mistake coming. Greenspan said that about the tech bust. Bernanke said that about the housing bust.

But this was more than just a mistake. This was an intentional policy decision that was driven by a seductive but completely idiotic theory: the idea, promulgated by Modern Monetary Theory acolytes, that if the economy is not at full employment the government can spend any amount of money and the central bank can print it, and it will not cause inflation. The last two years were an experiment, testing that proposition. Massive government spending, financed by bond sales that the Fed promptly bought, was nothing more than MMT and lots of people said so at the time, including this author. In January 2021, right after the first stimmy checks went out, I wrote this:

So I expect that as things go back to normal, inflation will rise – and probably a lot.

This is the test! Modern Monetary Theory holds you can print all you want, with no consequences, subject to certain not-really-binding constraints. The last person who offered me free wealth with no risk was a Nigerian prince, and I didn’t believe him either. I will say though that if MMT works, then we’ve been doing monetary policy wrong for a hundred years (but then, we also leached people to cure them, for hundreds of years) and all of our historical explanations are wrong – and someone will have to explain why in the past, the price level always followed the GDP-adjusted money supply.

…and I’d also said something like that in November 2020. And in March 2020. And I certainly wasn’t alone. The meme that “MMT” stood for “Magic Money Tree” was well-traveled.

So this is in no way unforeseen. The prediction in advance was that this behavior would provoke very high inflation. And the MMTers said “pshaw.” They were wrong, and that experiment is over. The next person who mentions MMT, you are entitled to run out of town on a rail.

That’s the good news. [I will say that I did not believe the Fed would get religion this quickly, but then they also haven’t been punished by asset markets yet for turning hawkish. Still, I didn’t really think the Fed would get to 1% before they’d start reversing course, and I was definitely wrong on that!]

But now the bad news. We are starting a new experiment, and unlike the last one this experiment isn’t as obvious. The Federal Reserve is now, for the first time, trying to control high inflation by changing only the price of money, with no pressure at all on the quantity of money. Always before, the Fed changed interest rates by putting pressure on reserves. Banks that wanted to continue to lend had to bid up those scarce reserves, and so interest rates rose. As I’ve written frequently (and even talked about in my book “What’s Wrong With Money?” six years ago!), that isn’t how it’s done today. Banks live in a world where lending is not reserve-constrained at all, and only capital-constrained.

Changing interest rates, without putting pressure on reserves to drag down money growth, is an experiment just like MMT was an experiment. The Fed has models. Oh yes, they have models. Gobs of models. Given what we’ve just gone through, how much confidence do you have in their models? Here’s the thing. Raising interest rates, if banks have unlimited lending power, probably[1] means more money and not less. That’s because banks are very elastic when it comes to making profitable loans. Give them more spread, or a higher yield over funding, and they will lend a bunch of money. On the other hand, borrowers tend to be less elastic. If you’re a consumer who has an 11% consumer loan, and it goes up to 12%, is that really going to make you borrow less? Mortgage origination is one place where you’d expect to see an elastic demand response to higher rates, but less than you might think when home prices are rising 15% per year. In short, if you don’t restrain banks by pressuring reserves, I suspect it’s very likely that you get more lending, not less, with higher interest rates.

But we don’t really know one way or the other.

What concerns me now is that at least with MMT, we knew it was an experiment. It may have been a stupid experiment, or merely an excuse to do ‘transformational’ things in response to the COVID recession, but we knew we were doing things we had never done before. When we talk about interest rate policy, though, there aren’t a lot of people who think the Fed is doing anything new. People think that the Fed always operates by raising interest rates, because we “know” that “tightening policy” is synonymous with rate hikes. The problem is, that’s a mental shorthand. That isn’t, in fact, the way the Fed has historically operated. When the Fed was doinking around with inflation between 1% and 3%, the precise mechanism didn’t really matter – the Fed’s actions probably didn’t have any meaningful effect one way or the other. Now, however, we are in a dreadfully important time. There’s a reason that NASA tests rockets without anyone aboard, before they strap anybody to it. We, though, are all involuntary participants in this experiment.

Hope it ends better than the last one.


[1] Fine, fine, this is speculation on my part too because I haven’t done it either. But my forecasting record is better than the Fed’s.

Summary of My Post-CPI Tweets (May 2022)

June 10, 2022 2 comments

Below is a summary of my post-CPI tweets. You can (and should!) follow me @inflation_guy. Or, sign up for email updates to my occasional articles here. Investors, issuers and risk managers with interests in this area be sure to stop by Enduring Investments! Get the Inflation Guy app in your app store! Check out the Inflation Guy podcast!

  • It’s #CPI Day and, possibly, mea culpa day.
  • Last month I, & most everyone else, said the CPI peak was behind us as it dropped from 8.5% to 8.3%. In fact, I went out of my way to be sure people understand that peak CPI doesn’t mean peak PRICES (see my podcast at https://inflationguy.podbean.com/e/ep-28-this-month-s-cpi-report-peak-changes-not-peak-prices/ , e.g.)
  • We may have been premature. Today, while the consensus estimate is that headline will print 8.3% y/y the interbank market is exchanging that risk at 8.48%. And moreover, prices in the interbank market have the best guesses for headline CPI above 8.6% until October.
  • Of course that is because gasoline prices did NOT peak and kept on climbing. The national average is about to surpass $5/gallon. And this is keeping headline inflation bid.
  • Core CPI is still very likely to decline y/y. Consensus for the m/m is 0.5%, and the comp from May 2021 is +0.75%, so core should drop. The m/m consensus seems a little low, but 6 of the last 7 core prints have been between +0.5% and +0.6% so we are probably talking shading.
  • And I focus on Median CPI, which is still rising. It will keep going up for at least a few more months. And this is the salient point. Median is the best measure of the main thrust of the distribution – and while it’s rising, you can’t say price pressures have peaked yet.
  • Before I go on: after my comments on the number, I will post a summary at https://mikeashton.wordpress.com and later it will be podcasted at https://inflationguy.podbean.com . And all of that also will be linked on the Inflation Guy mobile app.
  • In the bad news category this month, new cars and apparel are likely to continue to be contributors. Used cars are a little less clear. But these are three of the big “core goods”. So it isn’t just used cars. It was never just used cars, of course. That was just a foil.
  • Also in the bad news category for the general inflation outlook (although not for this month’s CPI perhaps) is that wages are still accelerating. The Atlanta Fed Wage Growth Tracker is now up at 6.1% y/y.
  • The good news is those wages are maintaining a steady spread over median CPI. Bad news is that so far gasoline and food aren’t mean-reverting and so the wage slaves of the world (and that’s most of us) are still getting killed. But maybe apres le deluge things will be better.
  • Hey, more good news is that M2 is decelerating. It’s down to 8% y/y, and only 1-2% over the last 3 months. Problem is that prices still haven’t caught up with the money growth SO FAR, but at least maybe we’re stopping the digging of the hole. Early to say that yet.
  • Unfortunately, commercial bank credit is growing at 9.5% y/y. Which is exactly what you would expect when non-reserve-constrained banks are able to lend at higher market rates.
  • This is one of the mechanisms for velocity rising when rates go up: the supply of credit gets better, and the demand for credit is fairly inelastic (50bps means more to your bank than it does to you).
  • We have never ever tried to restrain inflation with rates alone. Repeat that to yourself: monetary policymakers have NEVER tried to restrain inflation anything like this level with just interest rates. In the past, they restricted reserves. Not this time. So, here’s hoping.
  • Pretty short walk-up today but that’s because all the stories are the same: rents, and breadth, and we are still looking for a peak. Rents still look strong, breadth is still wide, and the peak in headline and median appears to still be ahead.
  • Question to ponder is: if CPI hits a new high, how bad for equities is that? If inflation stays at 6% for 2022, how long can the Fed sell the idea that 2.75% is the highest they’ll need to hike? The Eurodollar curve doesn’t believe it, but it also thinks this is all over in 2023.
  • I’m still thinking the Fed will pause the first time stocks get sloppy or unemployment starts to rise, but maybe I’m wrong. So far no signs of that. Still, they’ve not been tested yet.
  • OK, number in a few. Good luck.

  • ok, well…I guess we weren’t at peak CPI yet. M/M headline +1%; Y/Y up to 8.6%. Core slipped, but not as far as expected. To 6.01%. The decline is base effects. Bad news is that this is the HIGHEST m/m core CPI since last June.
  • It wasn’t just gasoline helping the headline to new highs; Food & Beverages was +1.13% m/m, now up to +9.73% y/y. Again, that hurts the wage earners most.
  • Used Cars was +1.8% m/m. New cars +0.96% m/m. Airfares, after +19% last month, were +12.6% this month. And can I say, the quality of air travel is as bad as I can remember it, speaking anecdotally.
  • Remember how everyone said that when core goods inflation came down, this would pass? Well, it is! core goods fell to 8.5% y/y from 9.7%. But core services jumped to 5.2% from 4.9%.
  • Owners’ Equivalent Rent leapt +0.6% m/m and now at 5.1% y/y. Primary Rents +0.63%. I have to look back and see the last time we saw any m/m jump that big. Lodging Away From Home +0.9%. So Housing subcategory was +0.85% m/m, +6.9% y/y.
  • That was the biggest m/m change in OER since 1990. And it doesn’t look like it’s rolling over.
  • Doctors’ Services fell -0.14% m/m, and are at only +1.1% y/y. Amazing. Hospital Services +0.46% m/m, so y/y went to 3.87%. Overall Medical Care subcategory was +0.4% m/m, to 3.74% y/y.
  • Core inflation ex-housing declined to 6.4% y/y. Yay!
  • This is kind of what I was afraid of. Housing inflation is moving above our model. It’s more in line with one of the subcomponents of the model, which is income-driven. And since wage income is still rising rapidly, there’s no reason to expect rents to slow very much.
  • More good news is that alcoholic beverages inflation is only +4.04% y/y. We’re gonna need it.
  • Household energy was +3.96% m/m. Fuel Oil +11% on the month, +76% y/y. Piped gas +7.8% m/m, +30.2% y/y. Electricity +1.9% m/m, +12% y/y. Break out those sweaters.
  • (That was an allusion to Jimmy Carter telling folks to turn down the thermostat and wear a sweater, in the 1970s energy crisis).
  • So Communication was -3.5% on the month. No idea what that is all about. Misc Personal Services was -1.3% m/m. Tenants and Household Insurance -0.8% m/m. Without that 5% of the basket declining, this would have been WORSE.
  • Median also looks like it should be 0.63% m/m or so. If true, that would be the biggest median since 1982. And folks…pressures aren’t ebbing; they’re BUILDING. Core highest in a year (m/m); median highest in decades.
  • About 8% of the consumption basket inflated faster than 9% annualized this month (m/m * 12, not y/y). That’s ridiculous. Normally there are a handful of outliers.
  • Four Pieces charts. Food and Energy, no surprises.
  • Piece 2, core goods. Like I said, good news. Dollar strength doesn’t hurt, but this ebbing is mostly due probably to declining trucking/shipping. Still not exactly soothing.
  • Piece 3 is core services less rent of shelter. Highest in a very long time. Over the last few years, this has persistently been the one spot that was showing gradual disinflation. No more.
  • Piece 4 rent of shelter – I’ve already discussed. It’s taking the top off my model.
  • As predicted, stocks not loving this. Short end of the Treasury curve also less than pleased.
  • I forgot: CPI for baby food unchanged on the month, +12.75% y/y.
  • One more chart and then I want to wrap up. The Enduring Investments Inflation Diffusion Index declined slightly this month, but still at a very high level. Those few weird negative categories might have rounded its edges a little. Nothing soothing though.
  • So, look. This was worse than even the pessimists were looking for. Housing accelerating to new levels, as a slow-moving category, is really, really bad news.
  • Headline inflation, thanks to continued rises in gasoline prices, may advance still further. Core inflation was down, and may be down again next month, but ONLY because of really rough comps. May-2021 (dropped off today) was +0.75%. June was +0.80%.
  • But then July, August, and September 2021, on core CPI, were +0.31%, 0.18%, and 0.26%. We’re going to shatter that. So core CPI probably doesn’t really peak until September…at best.
  • Meanwhile, Median CPI is still rising, months away from a peak also, and more importantly still setting new highs in m/m prints. That’s amazingly bad news.
  • We all know the Fed is behind the curve. And we know that their 2.75% terminal dot was based on the assumption that inflation would ebb to a level they think is the natural equilibrium around 2.25%.
  • That ain’t gonna happen. Now, that doesn’t mean they’ll hike rates to where they really need to be, but the choice between saving the nation from inflation on the one hand and saving the stock market on the other hand just got real.
  • Remember this chart. All of the models the Fed is using assume the canopener. They assume inflation is pulled by anchored expectations or some other potion to 2.25%. This is false.
  • Image
  • What am I saying? DEFEND YOUR MONEY. That’s all for today. You can catch this summary on https://mikeashton.wordpress.com later, and I’ll drop a podcast tonight. Stop by Enduring Investments if you feel so inclined. Thanks for tuning in.

Maybe we will look back on this day and say “that’s the day that everyone caught on that this inflation isn’t going to just gently fade away.” Every crisis has an inflection point where suddenly everyone realizes they’re on the wrong side of the boat – the day that our assumptions up to that point became plainly and obviously wrong. In the global financial crisis, the day that Lehman failed (without being merged into some other firm like Bear was) was the day when the last sleeping people woke up.

This isn’t quite so dramatic, but banks aren’t failing so it is what we have.

So, peak CPI isn’t yet behind us. Some of that is gasoline, of course. But the core CPI figures were also stronger-than-expected, and the strongest month in a year. Median CPI is still getting stronger every month, with new m/m records every month and y/y still rising. Rents are still accelerating. So not only are prices still rising, but inflationary pressures appear to still be rising even though in some cases (notably in core goods) there are some signs of improvement.

Those pressures should eventually ebb, if money supply growth remains flattish as it has over the last few months. But the price level has not yet caught up with prior increases in the money supply. Even after the microwave is turned off, the kernels in the popcorn bag still pop for a little while. That’s the best case at this point – that we are witnessing the final kernel pops.

Why Roughly 2.25% is an Equilibrium Real Rate

Recently, Fed officials have taken to discussing “long-term equilibrium” interest rates as a way of indicating to the market where interest rates might ultimately be heading. It is not exactly a terrifying prospect. The Fed seems to collectively believe that the “neutral” short-term nominal interest rate is in the 2.50%-2.75% range; some fear that the Fed funds target right may have to be lifted “modestly” above this level for a time. This seems hard to believe, with inflation running with an 8% handle – such an overnight rate would equate to an annual 5-6% incineration of purchasing power. The only way this could be considered “neutral” is if one begs the question by asserting contrary to evidence that the long-run equilibrium inflation rate is around 2%-2.25%.

I have noted repeatedly over the last year or so why it is unlikely in my opinion that the current equilibrium for inflation is in the 2% range; I feel it is closer to 4%-5% in the medium-term. But if an observer has a model which has been ‘trained’ on data from the last thirty years, the model will assuredly tell you that any time inflation deviates from 2%, it comes back to 2%. In fact, any model which did not produce that prediction would not have been considered a good model: it would have made predictions which, for 30 years, would have been noticeably incorrect from time to time. Ergo, all surviving models will view something like 2% as an attracting level for inflation, and we know the Fed continues to believe this. So, evidently, do many other economists. I keep showing this following chart because I think it’s delicious. Take today’s level; take the level your model says is a self-enforcing equilibrium, and draw a straight line. That’s your forecast. You too can be a million-dollar Wall Street economist.

Faced with awful predictions from this cadre of models, one solution is to consider why they had bad predictions, and attempt to develop models that would perform on data from the 1970s and 1980s as well. A more attractive solution, from an institutional perspective, is to blame model-exogenous events. That is, “the model is fine; who could have foreseen that supply chain issues would have triggered such a large inflation?” And so, we preserve the FOMCs ability to continue making terrible forecasts.

Similarly, Minneapolis Fed President Neel Kashkari stated not too long ago that the Fed may have to “push long-term real rates into restrictive territory.”[1] This continues the Fed’s error of obsessing on the price of liquidity rather than its quantity, but that isn’t the point I am making here. Kashkari made a different error, in an essay posted on the Minneapolis Fed website on May 6th.[2] He claimed that the neutral long-term real interest rate is around 0.25%, which conveniently is where long-term real rates are now.

However, we can demonstrate that logic, reinforced by history, indicates that long-term real rates ought to be in the neighborhood of the economy’s long-term real growth rate potential.

I will use the classic economist’s expedient of a desert-island economy. Consider such an island, which has two coconut-milk producers and for mathematical convenience no inflation, so that real and nominal quantities are the same. These producers are able to expand production and profits by about 2% per year by deploying new machinery to extract the milk from the coconuts. Now, let’s suppose that one of the producers offers to sell his company to the other, and to finance the purchase by lending money at 5%. The proposal will fall on deaf ears, since paying 5% to expand production and profits by 2% makes no sense. At that interest rate, either producer would rather be a banker. Conversely, suppose one producer offers to sell his company to the other and to finance the purchase at a 0% rate of interest – the buyer can pay off the loan over time with no interest charged. Now the buyer will jump at the chance, because he can pay off the loan with the increased production and keep more money in the bargain. The leverage granted him by this loan is very attractive. In this circumstance, the only way the deal is struck is if the lender is not good at math. Clearly, the lender could increase his wealth by 2% per year by producing coconut milk, but is choosing instead to maintain his current level of wealth. Perhaps he likes playing golf more than cracking coconuts.

In this economy, a lender cannot charge more than the natural growth in production since a borrower will not intentionally reduce his real wealth by borrowing to buy an asset that returns less than the loan costs. And a lender will not intentionally reduce his real wealth by lending at a rate lower than he could expand his wealth by producing. Thus, the natural real rate of interest will tend to be in equilibrium at the natural real rate of economic growth. Lower real interest rates will induce leveraging of productive activities; higher real interest rates will result in deleveraging.

This isn’t only true of the coconut economy, although I would strongly caution that this isn’t exactly a trading model and only a natural tendency with a long history. The chart below shows (1) a naïve real 10-year yield created by taking the 10-year nominal Treasury yield and subtracting trailing 1-year inflation, in purple; (2) a real yield series derived from a research paper by Shanken & Kothari, in red; (3) the Enduring Investments real yield series, in green, and (4) 10y TIPS, in black.

The long-term averages for these four series are as follows:

  • Naïve real: 2.34%
  • Shanken/Kothari: 3.13%
  • Enduring Investments: 2.34%
  • 10y TIPS: 1.39%
  • Shanken/Kothari thru 2007; 10y TIPS from 2007-present: 2.50%

It isn’t just a coincidence that calculating a long-term average of long-term real interest rates, no matter how you do it, ends up being about 2.3%-2.5%. That is also close to the long-term real growth rate of the economy. Using Commerce Department data, the compounded annual US growth rate from 1954-2021 was 2.95%.

It is generally conceded that the economy’s sustainable growth rate has fallen over the last 50 years, although some people place great stock (no pun intended) on the productivity enhancements which power the fantasies of tech sector investors. I believe that something like 2.25%-2.50% is the long-term growth rate that the US economy can sustain, although global demographic trends may be dampening that further. Which in turn implies that something like 2.00%-2.25% is where long-term real interest rates should be, in equilibrium.[3] Kashkari says “We do know that neutral rates have been falling in advanced economies around the world due to factors outside the influence of monetary policy, such as demographics, technology developments and trade.” Except that we don’t know anything of the sort, since there is a strong argument against each of these totems. Abbreviating, those counterarguments are (a) aging demographics is a supply shock which should decrease output and raise prices with the singular counterargument of Japan also happening to be the country with the lowest growth rate in money in the last three decades; (b) productivity has been improving since the Middle Ages, and there is no evidence that it is improving noticeably faster today – and if it did, that would raise the expected real growth rate and the demand for money; and (c) while trade certainly was a following wind for the last quarter century, every indication is that it is going to be the opposite sign for the next decade. It is time to retire these shibboleths. Real interest rates have been kept artificially too low for far too long, inducing excessive financial leverage. They will eventually return to equilibrium…but it will be a long and painful process.


[1] https://www.reuters.com/business/finance/feds-kashkari-we-may-have-push-long-term-real-rates-into-restrictive-territory-2022-05-06/

[2] https://www.minneapolisfed.org/article/2022/policy-has-tightened-a-lot-is-it-enough

[3] The reason that real interest rates will be slightly lower than real growth rates is that real interest rates are typically computed using the Consumer Price Index, which is generally slightly higher than the GDP Deflator.

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