Fed correctly signals an easing bias - and there's no need to be concerned about it causing higher inflation
With the M2 money supply falling and disinflation deepening, the key question isn't whether the Fed should have switched to a loosening bias, but whether it will unwind its tightening fast enough.
After aggressive interest rate hikes and ongoing QT, the Fed has made its long-awaited shift to a loosening bias, with equities, bonds, gold and silver all rallying significantly in response.
In this update, I will unpack two key questions that many may have in response, being: 1) what exactly did the Fed announce? and 2) will it lead to a resurgence in inflation?
I will then make some concluding remarks — let’s dig in.
What exactly did the Fed announce? 📣
The Fed’s latest FOMC meeting resulted in several important updates.
Starting with the Fed’s latest FOMC statement, it:
notes that recent indicators suggest that economic growth “has slowed from its strong pace in the third quarter”;
notes that “inflation has eased over the past year but remains elevated” versus the prior “inflation remains elevated”; and
adds the word “any” to the following statement: “In determining the extent of any additional policy firming that may be appropriate to return inflation to 2 percent over time, the Committee will take into account the cumulative tightening of monetary policy, the lags with which monetary policy affects economic activity and inflation, and economic and financial developments.’
In his FOMC press conference, Fed Chair Powell noted that the inclusion of the word “any” was in reference to the fact that FOMC participants do not currently expect any additional interest rate hikes to be delivered in the current cycle.
Turning to Fed’s latest Summary of Economic Projections (SEP), two important changes have been made. Firstly, the median year end 2024 federal funds rate estimate has been lowered from 5.1% to 4.6% — this implies approximately three 25bp rate cuts from current levels. Secondly, not a single FOMC participant currently expects to raise interest rates further in 2024.
As a result of this shift, and while not ruling out any additional rate hikes, Fed Chair Powell noted in his FOMC press conference that during the December meeting, some participants discussed when they should begin to dial back some of the policy restraint that is in place.
Fed Chair Powell also noted that real progress is being seen on inflation, including “very low numbers” on a 6-month basis — the major deceleration in 6-month annualised PCE inflation is something that I previously detailed in my latest PCE inflation analysis, where I argued that the Fed should pivot to a loosening bias.
Fed Chair Powell also noted that the Fed is “aware of the risk” that they “hang on too long [to a restrictive policy stance]” and that participants are “very focused on not making that mistake”. Furthermore, Powell noted that in light of the lags associated with the Fed’s policy decisions, that “you’d want to be reducing restriction on the economy well before 2% because -- or before you get to 2%, so you don’t overshoot”.
All-in-all, there’s only one way that the Fed’s latest announcements could be interpreted, and that is as a decisive shift towards a loosening bias — this is a message that markets clearly understood.
Will it lead to a resurgence in inflation? 📈📉
Given the significant decline in bond yields that has been seen following the announcements associated with the Fed’s latest FOMC meeting (at the time of writing, the 10-year Treasury yield has fallen to 3.92%, versus ~4.2% prior to the latest FOMC meeting), and the waves of inflation that were seen during the 1970s/80s, many may now be worried that the Fed’s dovish tilt will lead to a resurgence in inflation.
Given my belief that inflation is primarily driven by changes in the money supply, given that the M2 money supply currently recording YoY declines, I do not believe that the shift to a loosening bias will lead to an imminent resurgence in inflation.
This focus on the money supply has meant that I first warned of higher prices in August 2020, and then began to publicly state that US inflation had likely peaked and that there will be a significant reduction in inflation over time, as far back as September 2022.
For supply-chains didn’t cause high inflation. Neither did wage growth or corporate profiteering. Instead, all of these factors were a symptom of excessive growth in the M2 money supply — in 2020, annual average growth in the M2 money supply was the second highest in the US’ post-Civil War period.
While the additional liquidity from running down the TGA and the subsequent draining of the Fed’s RRP facility has helped to support economic growth in 2023, without another surge in the M2 money supply, there’s no foundation for another sustained surge in demand and prices — the mere shift to a loosening bias is unlikely to deliver such a surge in M2.
Instead, with the M2 money supply currently falling, CPI durables prices, which led the recent bout of high inflation, are now seeing material deflation. CPI nondurables prices are also once again on the verge of YoY deflation, whilst CPI adjusted core services prices (excluding indirectly measured health insurance, inconsistently measured household operations and lagging shelter costs), being the most lagging component, have also seen some disinflation.
With the disinflationary cycle now so deeply entrenched, and which according to the latest PCE and CPI data, is growing in strength, shifting to a loosening bias is very unlikely to imminently reverse this disinflationary trend — particularly given the Fed’s ongoing commitment to QT, which in isolation, acts to mechanically reduce banks deposits and the M2 money supply.
The waves of inflation during the 1970s/80s were driven by waves in the M2 money supply
While the 1970s/80s experience has many worried about the potential for a resurgence in inflation on the back of the Fed shifting to a loosening bias, it’s important to note that inflation moved in waves during this period for one key reason — the money supply moved in waves.
First goes the money supply, then, as the increased supply of money flows through the wider economy and bids up prices, inflation moves higher.
Going back further reveals that real rates aren’t the key to reducing inflation — instead, it’s growth in the money supply
While the 1970s/80s experience is what continues to garner the greatest historical reference, a more thorough analysis of historical inflationary periods also shows how strongly positive real rates are not essential to lowering inflation.
Instead, the key is to adequately control growth in the M2 money supply — achieve that, and high inflation will dissipate.
While positive real rates are a tool that can help to achieve a reduction in money supply growth, history shows that they are not a necessary precondition.
This was clearly seen during the WWI and WWII periods, whereby the Fed’s discount rate remained well below the rate of inflation, but high inflation nevertheless fell sharply (even reverting to outright annual average deflation), once growth in the M2 money supply moderated in the post-war periods.
A data driven approach shows that the Fed was correct to signal a loosening bias — the key question is instead whether it will loosen fast enough to avoid a recession
With both the PCE Price Index and the CPI recording major moderations in growth, bank lending growth slowing sharply, and the M2 money supply currently recording YoY declines, a data driven approach shows that the Fed’s shift to a loosening bias was the correct decision.
Indeed, rather than whether adopting a loosening bias was the correct decision, the key question is instead whether or not the Fed will wind back its tightening at a fast enough pace in 2024 to avert a potential recession, which has historically been the outcome that occurs in light of a falling M2 money supply.
While history shows that even a small decline in the M2 money supply after a very large increase can lead to a deflationary bust (as occurred in the post WWI period), that has not (yet) occurred today.
A key potential reason for the largely unexpected resilience of the US economy during 2023 can likely be explained by the huge swings in the Treasury General Account (TGA) and the Fed’s reverse repo (RRP) facility, which saw huge sums of “idle” balances shift into the real economy.
The TGA fell from a peak of $560bn in February, to $45bn in early June, while very large subsequent net T-bill issuance has acted to drain an enormous ~$1.6tn of “idle” funds from the Fed’s RRP facility — while some of this drain simply resulted in funds shifting from one “inert” source to another (the RRP to the TGA), to the extent that it has funded deficit spending, it has acted to stimulate the economy, offsetting some of the drag from the Fed’s tightening.
While a declining M2 money supply indicates that economic risks are materially elevated, a current RRP balance of $769bn also suggests that overall liquidity levels remain ample, and that the Fed can continue with QT for now.
Though with QT continuing at $95bn a month, and net T-bill issuance of $468bn currently expected in 1Q24, the offset to the Fed’s tightening from a declining RRP facility may be significantly exhausted over the months ahead — once this point is reached, the impact of the Fed’s tightening may begin to be more fully felt.
With the prospect of a drained RRP facility on the horizon, the M2 money supply already recording YoY declines, and disinflation deepening, now is not the time to be concerned about a resurgence in inflation.
Instead, it’s the soft landing narrative that should be questioned.
With the FOMC’s current projections indicating that the committee is firmly in the soft-landing camp, with its median expectation that the unemployment rate only sees a modest increase to an average of 4.1% in 4Q24, the current median FOMC estimate for ~70-75bps of rate cuts in 2024, may prove conservative.
Thank you for reading my latest research piece — I hope that it provided you with significant value.
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Inflation is far from a straightforward subject, so take this as intuition.
I can't help feeling that the position we're in at the moment, of having had a substantial rise in prices of basics, is extremely unstable. I'm not convinced that any policy can maintain prices at the current level. Either a realistic price level is restored, meaning all the price rises which were only maintained by bubble economics are undone via a period of deflation, or the Fed goes all-in on debasing the currency to try to avoid it, and ends up causing hyperinflation.
I think this is a suitable analogy: Imagine there's a table and a length of elastic with a pen mark in the middle, which is aligned with a mark on the table. Someone starts pulling the left end of the elastic to the left, so the marks are no longer aligned. The Fed tries to realign the marks by pulling the right end of the elastic to the right to compensate. It might be able to keep them almost aligned for a while, but it gets harder over time to judge the right amount of force to use, and eventually the elastic snaps, with its mark shooting one way or the other at high speed.