It’s no secret that an aggressive tightening of monetary policy can pose a real threat to the health of the economy. But even if the Fed surprises us with a 50 basis point hike in short-term rates next month and even 4-5 more hikes by the end of the year, policy will remain extremely accommodative. It will take a long time for Fed policy to become “tight,” let alone too tight. If this turns out to be the case, then, by inference, inflation is very likely to be higher than the market expects, and for longer.
As I’ve noted in recent articles, there’s one huge thing missing from all the inflation buzz: the increase in the M2 money supply. And in virtually every discussion of inflation, almost everyone fails to mention that a widespread increase in many prices can only occur when there is a clear increase in the money supply. If the Fed is doing its job, the money supply should equal the money demand. But if the Fed allows the supply of money to exceed the demand for money, that is equivalent to increasing everyone’s purchasing power: more money is needed to cause a general increase in the money supply. Without extra money in people’s pockets, higher energy prices (for example) mean consumers have less money to spend on other things. But when the prices of energy, commodities, autos, homes, and food rise significantly, that’s virtual proof that there’s excess money in the system. Which can only be solved if the Fed adopts policies that increase the demand for money and reduce the supply of money.
Here are some handy charts to use for reference as Fed policy moves forward.
Chart #1 is the best way to see if monetary policy is restrictive or not. Notice the patterns that have repeated themselves over the decades (with the exception of the sudden drop in GDP two years ago): before each recession, the real fed funds rate jumped to at least 3-4% and the slope of the yield curve has changed to negative. These are classic characteristics of tight money. Why? Because the Fed must raise real short-term rates to a level that discourages borrowing and encourages saving (ie, to a level that stimulates the demand for money). As real rates rise, the demand for money becomes intense, liquidity becomes scarce, and fringe businesses are squeezed. The bond market realizes that the economic weakness is spreading and begins to anticipate a reduction in the real federal funds rate in the future – so that long-term rates fall at or below the level of short-term rates. . Currently, these two variables are not even close to suggesting that monetary policy is or is about to become restrictive.
As a first-pass estimate, the fed funds rate must be at least equal to the rate of inflation for monetary policy to become restrictive. If short-term rates are below the level of inflation, this in itself serves to weaken the demand for money (and encourage borrowing), thus allowing inflationary psychology to persist. If we don’t see M2 growth starting to decline soon (it’s currently growing at double-digit rates), you can expect to see inflation of at least 7% for some time to come. Unfortunately, the Fed only releases money supply data once a month; we will have to wait a few more weeks to see what happened in January.
Chart #2 shows the bond market’s expectations of future inflation (green line). Currently, the market expects the CPI to average around 2.8% per year over the next 5 years. That’s a bit above the Fed’s target, but only modestly. This means that the market realizes that inflation is going to be above average for the next few years, but the market is still convinced that the Fed is not going to lose control of the situation. (The Fed defines “loss of control” as “inflation expectations becoming loose.”) I’m all for trusting the Fed, but I also like to check, and so far, they fail on this point.
Small businesses far outnumber large businesses, so it’s important to know what small business owners think. This is illustrated in Chart 3, which measures the general level of optimism among small business owners. Optimism has fallen in recent years, but is only slightly below its long-term average. Things could be better, but they’re not terrible yet. The economy is still very likely to continue to grow, as job openings are unusually plentiful and there are still plenty of people ready to return to work, as shown in Chart 4. Things could be much worse.
Chart #5 shows the major problem cited by a majority of small businesses: prices are rising at high speed.
More than a quarter of small businesses report paying their workers more (see Chart 6). Although the number has fallen in the past month, it remains exceptionally high. As Chart 5 also shows, today’s inflation has much in common with the inflation of the late 1970s.
It is quite impressive that a wide range of prices – industrial metals, agriculture prices, energy prices, real estate prices, etc.) are up, and significantly so. Over the past two years, many have nearly doubled in price. Chart 7 shows industrial commodity prices (red line) which are up nearly 50% since just before Covid hit. It’s also worth noting that in the past, commodity prices tended to move inversely to the strength of the dollar: a strong dollar drove prices down, while a weak dollar helped drive up prices. These days, that relationship seems to have reversed: the dollar is relatively strong, but prices are soaring. I think this reflects a lot of excess money coupled with a general resumption of many activities (eg construction, new plant and equipment) that have been suspended during Covid.
Chart 8 shows 2-year swap spreads in the United States and the euro zone. Swap spreads are a very liquid indicator of a) general liquidity conditions, b) the health of the economy, and c) the outlook for corporate earnings. US swap spreads are currently trading around the middle of what could be considered a “normal” range. Eurozone swap spreads are a bit high, which likely reflects the fact that the outlook for the Eurozone economy is decidedly less optimistic than that of the United States. No surprise: the US stock market has outperformed the eurozone stock market by around 85% over the past decade. A normal level of swap spreads here suggests abundant levels of liquidity and signals a good outlook for the economy and corporate earnings.
Finally, Chart 9 shows 5-year credit default swap rates. Like swap spreads, they are highly liquid indicators of corporate earnings prospects. Although the spreads have widened a bit (for fear that the Fed will tighten too much or too quickly), they are still well within what could be considered a normal range. The Fed has yet to inflict any damage on the fundamentals of the economy.
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.