Monetary Muddle

The Federal Reserve raised short-term interest rates by three-quarters of a percentage point (75 basis points) on Wednesday. The day before, the Fed had released M2 money supply data for June and it fell slightly, the second decline in three months. At his press conference after the rate hike, Fed Chairman Jerome Powell was vague about the Fed’s future intentions on rates, but was not asked one single question about the money supply.

For now, with the federal funds rate at 2.375%, the futures market is leaning toward a rate hike of 50 bps in September. The Fed has apparently abandoned “forward guidance” partly because it has already pushed rates close to what many Fed members said is “neutral.”

Meanwhile, the 10-year Treasury yield has fallen from north of 3.4% to under 2.7% suggesting the market thinks the Fed will either slow down rate hikes, or maybe even cut them next year. Unless, inflation falls precipitously, this makes no sense. “Core” PCE inflation is closing in on 5% and a “neutral” interest rate should be at least that high, or higher. The Fed has never managed policy under its new abundant reserve system with inflation rising this fast. No one, even the Fed, knows exactly how rate hikes will affect the economy under this new system. (See MMO)

Many think the economy is in recession already, because of two consecutive quarters of declining real GDP. But this is a simplified definition. Go to NBER.Org to see the actual definition of recession. A broad array of spending, income, production and jobs data rose in the first six months of 2022. GDP is not a great real-time measure of overall economic activity for many reasons. Jerome Powell does not think the US is in recession, and neither do we. What we do know is that inflation is still extremely high and the only way to get it down and keep it down is by slowing money growth.

And that does look like it’s happening. So far this year, M2 is up at only a 1.7% annual rate, after climbing at an 18.4% annual rate in 2020-21. By contrast, M2 grew at a 6.2% annual rate in the ten years leading up to COVID.