If you believe in the Milton Friedman adage that inflation is always and everywhere a monetary phenomenon, then you should also believe that the Federal Reserve can stop increasing interest rates. Now.
Raising its target rate rapidly from near zero early last year to 4.50% in December made sense not just with core inflation surging above 6%, but also with the money supply measured by M2 soaring by almost $6 trillion, or some 41%, as the government flooded the economy with cash to support consumers and businesses during the pandemic.
But while inflation has come down slowly, growth in the money supply has quickly decelerated, contracting on a year-over-year basis for the first time since at least 1960, according to Fed data compiled by Bloomberg. Perhaps more important, a broader measure of M2 that tracks checking accounts, saving accounts, money market accounts and short-term certificates of deposit as well as other liquid deposits has already turned negative on a year-over-year basis, tumbling $1.35 trillion from the peak in March to $12.4 trillion in December, a drop of 9.8% In other words, the money supply is shrinking.
The Fed’s rate increases, which came at a pace not seen since the days of Paul Volcker in the early 1980s, have had a hand in reducing the money supply and the excess savings that consumers accumulated during the pandemic. In essence, consumers have had to tap into their savings to cover higher interest payments on everything from mortgages to auto loans and credit card balances — or to avoid them by paying cash for bigger-ticket goods. The real estate market is a prime example. Some 30% of homes purchased in December were bought with cash, the highest percentage in eight years, according to property research firm Redfin.
All of this can be seen in the saving rate, which has fallen steadily, dropping to 2.2% in October from more than 7% a year earlier and marking the lowest level since 2005. The decline perfectly matches the drop in the broader measure of M2 from a high of $13.8 trillion in March to $12.6 trillion in November, the last month for which data are available.
These patterns in the data also suggest lower-income and middle-class Americans are holding off on major purchases to avoid having high interest payments cut into their checking account balances, while the more affluent keep the economy going with all-cash purchases. Some of this can be seen in the December retail sales report from the Commerce Department last Wednesday. It showed purchases among a control group of consumers tumbled 0.7% last month, the most since December 2021 and more than the double the 0.3% drop forecast by economists surveyed by Bloomberg. The control-group results are important because they feed directly into the gross domestic product calculations.
The other thing to consider is that if consumer spending, which accounts for about two-thirds of the economy, is starting to soften, it should help to contain — or even pull down — inflation. This is where all those cash buyers for real estate come in. These purchasers are likely to be landlords, creating more supply in the rapidly weakening rental markets. RealPage Analytics estimates that apartment demand turned negative in the last quarter of 2022, the first time since 2009. Apartment List says rents fell nationally every month in the fourth quarter, adding to the recent disinflationary trend we’ve seen of late in the broad economy.
This all has major implications for monetary policy. The Fed has made it clear that it’s willing to drive up unemployment in an effort to cool consumer spending and bring an end to the worst bout of inflation the US has experienced in four decades. But the slowdown in consumer spending and the easing of inflation is happening with a tight labor market that has kept the unemployment rate at a 50-year low of 3.5% — increasing the odds of a so-called soft landing in the economy and avoiding a recession.
Put another way, the latest data are starting to suggest the economy might not require such fine tuning from the Fed after all. So, policymakers have the bandwidth to avoid raising rates when they meet next week and allow additional data to either confirm or reject the thesis that the money supply and the broader economy are nearly in balance again. James Bullard, the influential president of the Federal Reserve Bank of St. Louis, hinted several weeks ago that he might be open to such an approach. Bullard noted that M2 provided a strong signal during the pandemic that faster inflation was on its way and the Fed should take into account that the money-supply measure is falling now.
It’s not clear that the Fed needs to be restrictive. It simply needs to support the trends that are already taking hold, and that means halting the rate increases — at least for now.
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