We've told people to watch the M2 measure of money in order to understand whether inflation will cool down or heat up. The Fed only releases this data on a monthly basis. They used to release it weekly, and we think not doing so robs the world of important information, nonetheless for now it is monthly.
Today the Fed released May data on the M2 money supply and from our point of view, it was welcome news, signaling that the monetary surge propelling US inflation numbers to a four-decade high seems to be slowing. The amount of M2 money in circulation rose just 0.1% in May (after falling in April).
As a result, the 12-month change fell to 6.6%, the slowest growth rate since the pre-pandemic days of 2019. Six percent growth is what we would consider "normal" from a historical perspective, so this represents welcome progress. So far in 2022, the money supply has grown at a modest 3.1% annualized rate.
However, high inflation is likely to linger. The M2 measure of money grew at an 18% annualized rate in 2020-21, or roughly three times the "normal" rate, and it will take multiple years for the US economy to fully digest all that excess purchasing power even if the money supply slows in the year ahead. If the Fed really does want to achieve a soft landing for the US economy, the best option in our opinion is to somehow keep M2 growth at a below trend rate in the 2-4% range for the next few years.
It's worth noting that recent money supply growth is being affected by unusually large tax payments. In April the US Treasury posted a $308 billion surplus - the largest on record. This allowed the Treasury to shrink its own checking accounts. This caused April's M2 number to post a rare monthly decline and it clearly could have affected M2 in May as well. It's possible this is just a temporary factor holding back M2 growth rates, and the Treasury will certainly not run a surplus this year. We will get a clearer picture in the months ahead.
With the Fed having stopped expanding its balance sheet, there is still no guarantee that M2 will continue to decelerate. The only way to truly slow down the growth rate of M2 is by holding back loan growth in the private banking sector.
Unfortunately, simply raising short-term interest rates may not work. With so many excess reserves in the system, will banks just accept what the Fed is paying? What rate is high enough for them to slow lending, or even reverse it? Or will the Fed increase the burden of capital requirements and liquidity ratios to constrain banks? The Fed has completely moved away from the reserve scarcity model it used prior to quantitative easing in 2008. No one, not even the Fed knows how all this works in a world of overly abundant reserves. We will keep watching M2...but, at least for the moment, things appear to be moving in a direction that will bring down inflation in the years ahead.
Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist
The Fed’s Balance Sheet Caused Inflation, Not Low Interest Rates
The Fed’s balance sheet as a percentage of GDP is what is driving today’s inflation -- not the nominal Fed Funds rate. This will emerge as a major risk to stocks and bonds if not managed soon. The chart below shows it was not the level of interest rates that contributed to higher inflation, but the Fed maintaining the size of the balance sheet at too-high levels for too long. If economic growth slows as many expect, the influence the balance sheet has on GDP will be even greater and may pose a potential catastrophic risk to stocks and bonds. As growth slows, so must the balance sheet to maintain the equilibrium between supply and demand. The market will decide the level of rates; the Fed can just follow along. Supporters of a change believe it would force companies to do more to curb illegal or dangerous behavior — from drug sales to disinformation with equally harmful consequences.
GOVERNORS ARE NOT MAKING THE FED’S JOB ANY EASIER WITH NEW CHECKS BEING DISTRIBUTED TO TAXPAYERS
23 Million Californians To Get 'Inflation Relief' Payments After Budget Deal Struck, State Leaders Say Millions of California taxpayers will get “inflation relief” tax rebate payments after lawmakers have reached an agreement on the framework of the 2022-23 budget. The deal also suspends the state’s sales tax on diesel. “The centerpiece of the agreement, a $17 billion inflation relief package, will offer tax refunds to millions of working Californians,” said a joint statement from Gov. Gavin Newsom, Senate President pro Tempore Toni Atkins and Assembly Speaker Anthony Rendon on Sunday night. The framework includes giving 23 million Californians direct payments of up to $1,050. The payments would be issued via direct deposit refunds or debit cards to tax filers by late October, according to the Newsom administration. The state’s Franchise Tax Board estimates that all would be issued by the end of 2022 or early next year.
Both monetary and federal fiscal policy are tightening. There is a reluctance to think about new fiscal aid with inflation high. But at the state level, we are seeing the opposite effect as state budget deadlines this week are forcing governors to distribute significant aid to consumers. California is getting the most attention with $17bn of aid to consumers. We expect more states to have similar headlines, ultimately culminating in $100bn of state aid. But the California story is contradictory. Despite the highest gas prices in the country, and with a budget surplus approaching $100bn, the governor announced the gasoline tax will be raised once again on July 1st. To offset this tax increase and the already high gas prices, the state government is simultaneously planning on sending checks of up to $1,050 to residents, at a time when further fiscal stimulus will only make the Fed’s job more difficult.
CA GAS TAX REVENUES, PRICES AT ALL-TIME HIGHS
Gas tax revenues in California are near all-time highs; gas prices in California are more than $1.40 higher than the national average; and the national real per capita disposable income data shows income growth is turning negative, but the state is nonetheless pushing ahead with the scheduled gas tax increase. For the time being, climate goals remain the priority over energy security and affordability.