We have gone from inflation fears to recessions fears in the global financial markets in recent weeks, which mostly reflects the fact that we gone from a situation where the markets were thinking that the Federal Reserve was behind the curve to a situation where market partipants now seems to think the Fed is overdoing it on monetary tightening.

But what is really happening in the US economy? I will try to explain that by having a closer look at US domestic spending – more precisely US* nominal* domestic spending.

To do that lets have a look at my favourite tool in the monetarist toolbox – the equation of exchange:

M*V = P*Y

Where M is the money supply (for example M2), V is money-velocity, P is the price level and Y is real GDP.

Both sides of the equation (both MV and PY) are measures of nominal domestic spending.

If we ASSUME that V is constant – it is not necessarily – then it follows that M = P*Y and then M and PY are measures of domestic spending.

We normally define the money supply in its most simple form as coins and notes in circulation plus bank deposits.

Consequently if bank deposits is the primary part of the money supply (it is) then the development in bank deposits also becomes a measure of domestic spending. The good thing about deposits is that we have weekly data, which means deposits is a high-frequency measure of domestic spending.

Finally, we can measures P*Y in two ways – either from the production side (we call that Gross Domestic Product) or from the income side (we call that Gross Domestic Income).

Both GDP and GDI are quarterly data. However, we have monthly data for Personal Consumption Expenditure (PCE), which historically has followed the development in GDP and GDI closely. We can therefore use PCE as a monthly proxy for domestic spending.

This give us five measures of US nominal domestic spending:

- M2
- Bank deposits
- GDP
- GDI
- PCE

**Very strong nominal domestic spending growth in 2021**

The graph below shows the five measures of nominal domestic spending.

We see that all five indicators through 2021 grew more or less in parallel and that the growth rate was very strong – hence all five indicators were 9-11% higher by the of 2021 than in the beginning of the year.

It is there for not surprising (at least not to any monetarist) that inflation picked up very strongly in 2021.

Said, in another way if real potential production growth is around 2% in the US then we should expect 9-11% nominal domestic spending growth to lead to 7-9% inflation. This is of course exactly what we have seen.

The need for monetary tightening – and hence a slowdown in nominal domestic spending growth therefore should have been obvious to anybody already during 2021.

*Domestic spending has slowed markedly in 2022*

The Federal Reserve unfortunately took much longer to realise the need for tighter monetary policy.

However, after Fed chairman Jerome Powell was reappointed in late November 2021 the Fed has started to move towards monetary tigtening and already from around October 2021 the financial markets gradually started to price in interest rate hikes from the Fed.

The graph above of our five measures of nominal domestic spending shows a pretty clear “flattening” of all fives measures starting in late 2021.

Another way of looking at this is to look at the growth rates of the more high-frequent measures of domestic spending – PCE, M2 and deposits and compare that to the yield curve as a measures of the financial markets expectations of Fed-tigthening. The graph below shows that.

We see that around Powell’s reappointed – in October-November 2021 the yield curve measured as the spread between 10-year and 2-year US government bond yields started to inch down and soon after that happened our measures of nominal domestic spending started to slow.

In fact all three measures has continued to slow. However, it is also notable that since April this year the yield curve has been more or less flat, which indicates that slowdown in nominal domestic spending likely soon will come to an end.

Hence, we are not seeing a negative ‘shock’ to domestic spending – it is ‘just’ slowing. That being said, the growth in nominal spending seems to nearly completely stopped – at least judging from our most high-frequent measure – bank deposits as the graph below shows.

If this continues for long then US monetary policy goes from inflationary to deflationary – and this obviously is what the markets are now reacting to.

However, year-on-year growth in nominal domestic demand in the US in Q2-Q3 is likely to be 6-8% so it is far to early for the Fed to change course and monetary policy in the US is *not* recessionary at the moment.

Rather monetary policy has rightly been tightened to undo the far too easy monetary policy during the second half of 2020 and all through 2021.

The challenge for the Fed now clearly is that there has been a massive expansion of the US money supply (for example M2) and it will take time for the Fed to suck up that exess liquidity.

We can illustrate that by zooming out a bit and looking at the development in M2 in recent years.

So yes, we see the same flatting the in line in M2 as we see in depostis in the last 3-6 month, but we clearly also see that the ** level** of M2 is way above the pre-2020 trend line. A trend line that more or less ensured 2% inflation in the US from 2010 to 2020.

So if the Fed just “let go” once the markets start to worry about a recession then we might very soon see domestic spending picking up speed again.

Therefore, the challenge for the Fed is to make sure that nominal domestic growth at a growth rate, which is comparable with inflation around 2% in the medium-term. That would likely mean that nominal domestic spending growth should be around 4%.

We are growing somewhat slower than that now (on a annualised monthly basis), but this is also necessary in a transition period where the Fed need to convince the market that it will not once again go back to the inflationary policies of 2020-21.

If the Fed is able to stick to this – then we should relatively soon begin to see US inflation inch down gradually. How fast inflation will be coming down will ultimately depend on what growth path nominal domestic spending settles at and the Fed is fully in charge of that.

## Steve

/ July 2, 2022Your last two posts have been excellent, very useful and clear framework for thinking about where we are and where we are going. Thanks for sharing!