YES IT'S THE ECONOMY. . .M2 Money Supply, major precipitator of a recession, a downturn in 2023 "baked in the cake."

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". . . After serving a seemingly never-ending punch of nearly free money, as well as ample and predictable liquidity replenishments, inflation has forced central banks back into their traditional role of taking away the punch bowl. This overdue pivot involves an inherently unpopular journey of policy and communication adaptation.

The temptation to prematurely render this journey more comfortable in the face of recent gains would risk losing sight of the much greater prize — that of restoring the type of macro stability that is essential for enabling high, inclusive and sustainable economic well-being."

"All this has changed in the last year with the emergence of high and persistent inflation. The initial policy fumbles — of analysis, forecasting, communication and reaction — meant that the Fed, in particular, had to pivot sharply from relative complacency to uber-tightening, delivering since the summer an unprecedented four consecutive 0.75 percentage point interest-rate increases in the face of an already slowing economy.

Such front-loading of rate hikes was sure to attract criticism — from politicians, market participants and, most important, households facing soaring mortgage rates and companies confronting harsher financing terms.

BoE’s ‘courageous stand’

> The criticism mounted as inflation remained worrisomely high and the risk of recession rose significantly.

That criticism has eased somewhat in the last few weeks, starting with the Bank of England’s expert handling of a near meltdown in the financial system triggered by Prime Minister Liz Truss’s government going too far and too fast in cutting taxes.

This was followed by a courageous stand by the bank against both fiscal dominance, whereby governments force central banks to fund their excesses, and moral hazard, whereby markets push them to subsidise excessive risk-taking.

Finally, last week’s US inflation report, which was better than consensus forecasts, sparked a rally in stocks and bonds that loosened financial conditions and encouraged more investors to embrace the possibility of a “soft landing” and less Fed policy tightening.

Three key lessons

While greatly welcomed, this respite is far from guaranteed to continue. To manage it well, central banks — and the Fed in particular — would be well advised to apply three key lessons from this year’s experience.

1 > First, as uncomfortable as it is to face criticism on the policy journey to containing inflation, this pales in comparison to what would happen if central banks failed to deliver macroeconomic stability.

Specifically, the unpleasant alternative would be an “Arthur Burns Fed” that leads the economy into a stagflation morass that would be much worse in every respect — economically, financially, institutionally, politically and socially. This is important as the Fed considers how best to tweak its messaging, including forward policy guidance, after the latest inflation report.

2 > Second, given years of investors’ over-extension in risk-taking enabled by persistently cheap and readily available money, central banks should never underestimate the fragility of the financial system.

Rather than falling back into the trap of having monetary policy co-opted by the threat of unsettling financial instability, they should be busily formulating a broad range of a risk-based policy scenarios that involve the greater deployment of preemptive measures and, if needed, reactive tools.

3 > Finally, straight talk is particularly important at a time of such considerable domestic and global economic fluidity. It is also critical for institutions that wish, as they should, to maintain their operational autonomy in the context of strained accountability.

The Bank of England has been an impressive example in this regard, setting aside politically inclined remarks for frankness and professionalism about economic developments and prospects, be it the threat of inflation surging to 13 per cent in the absence of timely policy responses or the possibility of a recession extending into 2023.

After serving a seemingly never-ending punch of nearly free money, as well as ample and predictable liquidity replenishments, inflation has forced central banks back into their traditional role of taking away the punch bowl. This overdue pivot involves an inherently unpopular journey of policy and communication adaptation.

Mohamed A. El-Erian is a former chief executive officer of Pimco, he is president of Queens’ College, Cambridge; chief economic adviser at Allianz ; and chairman of Gramercy Fund Management.

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Paul Volcker, former Fed Chair 1979 to 1987.
Bettmann / Getty Images

Inflation cooled in October, but prices have been elevated for over 20 months now, raising concerns of stagflation.
That means the economy could be slammed with high unemployment, low growth, and persistent inflation - as well as a steep drop in stocks.
Here's what five experts have said about the risks of stagflation and why markets should be more concerned.

Inflation cooled more than expected in October's Consumer Price Index report - but prices are still well above the Fed's 2% target, and they've been above-target for 20 months now.

That "sticky" inflation has sparked fears of stagflation, a dreaded scenario where high inflation gets entrenched into expectations, slamming the economy with a whirlwind of slow growth, high unemployment (and yes, high prices).

Those conditions defined the US economy throughout the 1970s and early 1980s, pushing the Fed to hike rates past 19% in the early 1980s. That's the tightest monetary policy on record, and it spurred a recession and a stunning crash in the stock market.

Luckily, evidence for another potential crisis is mixed, and October's cool-down in inflation should help soothe some fears. Five-year expectations of inflation are still hovering around the 2% level, and experts have pointed out that inflation often lags behind the official statistics - meaning that prices could be overstated, and are even lower than the latest CPI suggests. Hiring is still tight, and unemployment remained in check at 3.7% in October, which means the labor market has held up amid the Fed's scramble to rein in prices.

As investors digest mixed signals on the direction of the economy, here's what five experts have said about the risk of stagflation descending on the US economy.

Henry Allen, Deutsche Bank analyst

Despite inflation cooling in recent months, markets are seriously underpricing the risks of returning back to 70s-style stagflation, Deutsche bank analyst Henry Allen wrote in a recent note.

Allen pointed that inflation has remained high for a significant portion of this year, and while headline inflation is on the downtrend, "sticky" prices - prices for goods and services that don't change frequently - were still accelerating in September's inflation report, and barely cooled by .03% percentage points in October. Together, those indicators are "seriously bad news," as they're major omens for inflation expectations getting embedded in the economy.

If inflation remains persistent, that would result in an even higher interest rate from the Fed, Allen warned, which could spell trouble for stocks: "If the experience of the 1970s repeats, investors are in for a prolonged period of negative real returns for both bond and equities," he said.

Mohamed El-Erian, Allianz chief economic advisor

Top economist Mohamed El-Erian believes the US is already headed into a stagflationary crisis, as seen by low levels of growth and high levels of inflation this year.

"We are slowly slipping into stagflation," El-Erian said in a recent interview with Bloomberg. "We may not end up doing enough on the inflation side and then end up in a recession for Europe, near recession for the US and for China."

El-Erian has sounded the alarm on rising inflation since 2021, and has become a loud critic of the Fed's policy response, and of the central bank's insistence that rising prices were "transitory" before aggressively hiking rates this year. That raises the probability of a downturn - but stagflation risks mean the Fed can't back down from its aggressive rate-hiking regime, he said, warning it would be another policy mistake to stop Fed tightening at this point.

"I don't think they can stop now. Because their credibility is so damaged that if they were to stop now, people would immediately say, 'This is the Federal Reserve of the 1970s. This is the flip-flopping Fed, and we will have prolonged stagflation,'" he warned in an interview with New York Magazine in October. "I'll tell you that the consequences of that are worse than the consequences of the Fed continuing."

"Dr. Doom" Nouriel Roubini, NYU Stern economics professor

Roubini, who has earned a reputation as Wall Street's top doomsayer, warned high inflation levels and high debt means the US could be slammed by a stagflationary debt crisis - a Frankenstein-style crash that combines aspects of 70s stagflation and the '08 financial crisis.

That means low growth, high unemployment, and a painful recession in the US, he warned. In a recent interview with Fortune, he estimated that a mild recession could send the S&P 500 down another 10%, and a severe recession could send the index falling 30% to the 2,700 level. Bonds, credit, and other assets could also see a crash, topping on more damage.

That market rout could also last for years, he warned, due to high levels of debt and ongoing supply issues around the world, which could delay any recovery for the market.

"We might be closer to a period like we saw between 1973 and 1982, where stocks dropped and stayed very, very low for a long time … We could have a long-term crash," Roubini said, adding that its severity would be comparable to what was seen in 2008.

Steve Hanke, John Hopkins University economics professor

Steve Hanke Johns Hopkins finance class — Portia Crowe/Business Insider

The Fed could easily drive the US into a stagflationary crisis next year, Hanke said, given elevated inflation and the high prospects for an incoming recession. In a recent op-ed for the Daily Caller, the top economist pointed to a contraction in the M2 money supply this year, which includes all cash, checking, and savings deposits in circulation. That's a major precipitator of a recession, he said, calling a downturn in 2023 "baked in the cake."

"Thanks to the Fed's monetary mismanagement, broad money (M2) in the US has contracted by 1.1% in the last 7 months," he tweeted in early November. "With that contraction, a recession is right around the corner. In 2023 we will see persistent inflation & a recession - a STAGFLATION," Hanke warned.

Michael Hartnett, Bank of America chief global stock strategist

The US has already been slammed with stagflation this year, Hartnett's team of strategists said in a note earlier this month.

"Inflation and stagflation was unanticipated in 2022… hence the $35 trillion collapse in asset valuations," the note said. In a separate note, Bank of America warned investors to prepare for the scenario that the next recession is stagflationary, given that it takes around a decade on average for a developed country to bring inflation back down to 2%, once prices pass the 5% threshold.

But it doesn't necessarily mean prolonged losses for the stock market, Hartnett's team said. Relative returns in 2022 closely follow what was seen in 1973 to 1974, the years when the inflation shock began to ease in. In the 70s, that prompted stocks to enter "one of the greatest bull markets of all time" - meaning that a major rally could soon take hold and spark a recovery for the market.

Read the original article on Business Insider

Interpretation

The "M2 Money Supply", also referred to as "M2 Money Stock", is a measure for the amount of currency in circulation. M2 includes M1 (physical cash and checkable deposits) as well as "less liquid money", such as saving bank accounts. The chart above plots the yearly M2 Growth Rate and the Inflation Rate, which is defined as the yearly change in the Consumer Price Index (CPI). When inflation is high, prices for goods and services rise and thus the purchasing power per unit of currency decreases.
Historically, M2 has grown along with the economy (see in the chart below). However, it has also grown along with Federal Debt to GDP during wars and recessions. In most recent history, M2 growth surpassed 10 percent in the crisis of 2001 and 2009, during which an expansionary monetary policy was deployed by the central bank, including large scale asset purchases.
According to Bannister and Forward (2002, page 28), Money supply growth and inflation are inexorably linked.

Data Sources

M2 Money Stock

Federal Reserve Bank of St. Louis: M2 Money Stock since 1959
United States Census Bureau: Historical Statistics of the United States, Colonial Times to 1970 (M2 Money Stock until 1959, Chapter X, pages 992-993). Following Bannister and Forward (page 28), M2 prior to 1959 is calculated by adding "Currency held by the public" + "Deposits adjusted, commercial banks" + "Bank vault cash" + "Monetary gold stock" + "Deposits at nonbank thrift institutions"

Inflation

Federal Reserve Bank of St. Louis: CPI since 1913
Robert Shiller Online Data: CPI from 1871 until 1913

US Gross Domestic Product

Federal Reserve Bank of St. Louis: US Gross Domestic Product
Congressional Budget Office: Historical Gross Domestic Product

Further Information

Investopedia: What is M2?
Investopedia: What is Inflation?

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14 November 2022