E-piphany

We have CPI coming up in a few days, but M2 came out recently and it is worth commenting about, so let me drop some thoughts about the state of money and velocity right now and the context we are operating in.

M2 grew 0.88% in February, causing the y/y change to rise to 4.88% (quarterly, however, it is 6.65% annualized). I saw somebody recently observe that money growth was about 6ish back before COVID, so this level is not very worrisome to that pundit. I think that’s wrong – not that this level is worrisome in the big picture, but the trend is bad and the current level is actually not consistent with low and stable inflation as it was prior to the late twenty-‘teens.

Before we get to that, let’s review the state of play for money velocity. Remember when velocity plunged early in COVID, and people said inflation wouldn’t happen because the transmission mechanism was broken? That comment was so funny it made me blow milk out of my nose, even though I wasn’t drinking milk. It was entirely an artifact of the different time frames over which the money supply was changing, compared to the time frames required for prices and output to change. MV=PQ, and M was changing suddenly. Since GDP can’t suddenly change 20%, money velocity became the capacitor that held the excess charge which slowly bled into prices. In my podcast, and occasionally in this blog, the image I shared was of a car rapidly accelerating away from a trailer hitched to it by a spring. At first, inertia keeps the trailer from traveling as fast as the car, and the spring stretches. Once the car stops accelerating, though, the spring compresses and the trailer catches up. The illustration below is courtesy of Lovart.ai.

So where are we? Here is the US monetary system over the 2019-2025 period showing total growth from December 2019. The x-axis shows the total percentage growth in money as a percentage of real output (M/Q). The y-axis shows the total change in the price level. Now, I have to point out that when I was talking about this, in 2021 or 2022, we were very far away from the diagonal line showing where the two changes are equal. And I said we would be going back to the line, and we went back to the line. People really ought to listen to me more.

The other way to look at this is that velocity is back almost to where it was prior to COVID.

So is there any problem here? Velocity is back to where it was, but if it’s stable and money is growing at 4.9% y/y, then P+Q grows at 4.9%, so 2% inflation with 3% growth…sounds pretty good.

This is where we review the “but 6% worked!” argument.

You can see from the chart that yes, since the late 1990s M2 grew at 5-10% and we never had much of an inflation problem. Why now? Well, during that period velocity was steadily declining – and that is the only way that you can sustain 6% money growth with 3% real economic growth and get 2% inflation. The question, then, was why velocity was declining. Remember, some people think this is a trend, because they don’t really understand what drives velocity. During that period, interest rates steadily declined. This was also a period of increasing globalization and a demographic dividend (more workers relative to the aged). Now, whether the interest rates declined because of those trends because both trends were disinflationary, or if interest rates declined because of a dovish Fed and they only got lucky because of those trends…I don’t know. But the point is that the largest driver of lower money velocity during that period was lower interest rates.

And interest rates are now approximately fair. Some people think they’re too low with inflation too hot, some people think they’re too high with economic growth seeming to slow, but let’s just say they’re not 300bps wrong at this point. Here is our velocity model. With lots of crazy volatility, it has velocity pretty close to on-target. Here’s the problem: the last time prior to COVID were as high as they are now (I’m looking at 5y Treasuries), it was also prior to the Global Financial Crisis and the regime of interest rate repression. Back in 2007, 5y rates were this high, and money velocity was about 2.0, some 40% higher than here. What is holding velocity down right now in our model is a very high level of economic policy uncertainty, which causes people to hold more cash than they otherwise would given the level of interest rates. Thanks to the war between the President and his allies on one side, and the minority party on the other side, not to mention the Iran war, there is a lot of uncertainty right now and that is causing people to conserve cash.

It won’t always be that way, but with M2 growing near 5%…it really needs to be that way. By the way, the money growth situation is a bit worse than it looks, too: there has in the last couple years been a fairly dramatic rise in the amount of non-M2 money that is growing in defi/crypto space. Bitcoin isn’t money, but stablecoins are very much like money. The scale of the Stablecoin money supply is small compared to the ‘off-chain’ money supply, but it is starting to get large enough to matter. Anyway, we know the sign of that growth, and it’s a big fat plus.

So no, 6% is not a stable rate of money growth going forward from here. This is not the early 2000s. It is not the 1990s. If we could manage to just have 6% growth, then we’re probably going to end up being in the mid-to-high-3s on inflation, and that’s tolerable. But if that’s the midpoint of money growth, then mid-to-high-3s is the midpoint on inflation with some periods a little below that and some periods a little above that.

Economies adapt, and an economy can work fine at 4-5% inflation or even higher as long as it is stable. But 4% inflation feels different than 2% inflation, and the economy will work differently in that sort of regime. Businesses will be more likely to pass through cost increases rather than absorb what they think are short-term variations (see “How Expecting Inflation Un-anchors Manufacturers’ Pricing Strategy”). Equilibrium equity prices are lower. Menu costs and search costs go up. And so on. We may already be seeing some of these long-term structural changes. The Fed just published a FEDS Notes entitled “Is the Inflation Process in Advanced Economies Different After the Pandemic?” The short answer? Yes it is. The question is, are we on track to get the inflation process back to the way it used to be? And the answer there appears at this juncture to be: no.