The Federal Reserve has released the monthly numbers for US monetary growth in February. As we can see from the graph below, and which was indicated from the weekly numbers(and for the components of M2) M2 growth declined further in February. And that is before the recent banking turmoil.

So, the US monetary policy has effectively gone from being extremely inflationary to now being almost deflationary.

It is therefore not surprising that bank problems are now arising. It is a completely natural consequence of the massive monetary tightening.

Given the insane expansion of the money supply in 2020-21, there was no way around tightening monetary policy. It is now quite clear that the Fed has overdone it.

It is therefore now very difficult to see how a recession in the US can be avoided. The damage has been done.

My overall assessment is that US monetary growth should be around 5-7% per year (under normal conditions) to ensure around 4% nominal GDP and therefore around 2% inflation.

And in the last year, M2 has dropped by 2.4%. This is the largest yearly decline in M2 EVER. Or rather since 1960, when the current M2 series began. The annualised monthly growth of M2 has been NEGATIVE since August last year and in January and Febuary M2 has dropped at an annual rate of 6-7 percent.

If we look at the real monetary growth, the decline is almost 8% (year-on-year), which further illustrates how drastic the monetary tightening is.

Back in January, I wrote a blog post “US inflation set to fall sharply in the coming quarters”, where I predicted a significant decline in US inflation. In that blog post, I presented two scenarios for future US M2 growth (a “hawkish” and a “dovish” scenario).

We are now on the tight side of the “hawkish” scenario. That is, monetary policy is becoming far too tight. In the hawkish scenario, the prospects were that US inflation would fall somewhat BELOW 2% in 2024-25. And that was without assuming any drastic changes in the velocity of money. In other words, given that money suppply growth is now even lower, there is now certainly a risk of DEFLATION in the US at some point in 2024-25.

Therefore, the Fed will also have to make a very strong turnaround in monetary policy if a severe recession is to be avoided (it is probably not possible to avoid the recession at this point), and if the Fed is to ensure that inflation does not fall significantly below 2%.

Milton Friedman, who recommended that the Fed ensure stable growth in the money supply (e.g. 4-6% per year), would have been just as concerned that we now have very negative M2 growth as he would have been about the very high M2 growth in 2021-22.

Unfortunately, I feel compelled to quote one of my other great heroes, the German-American economist Rudi Dornbusch:

“No postwar recovery has died in bed of old age—the Federal Reserve has murdered every one of them.”

And yes, the Fed will have to sharply lower interest rates in 2023-24. Sharper than what my simulation showed back in January (see here).

Finally the Fed should not concern itself with the so-called banking crisis. The Fed should not ease monetary policy because of that. The Fed is not in the business of saving banks. HOWEVER, the Fed’s job is to ensure nominal stability and consequently the Fed should now move to ease monetary policy fairly aggressively and that will own its own also greatly contribute to ensuring financial stability.

And do I need to say it again? The Fed needs to return to a rule based monetary policy and end the stop-go policies of recent years. My recommendation has for years for the Fed to adopt a 4 percent NGDP level target and I continue to believe that is the best target the Fed could adopt.

10 years ago I wrote a blog post with the title “Firefighter Arsonists – the myth of the central bankers as ‘good’ crisis managers”. Given what is playing out in the global economy it seems fitting to update that post.

So that is what I have done. Here goes…

10 years ago Ezra Klein endorsing Larry Summer argued that Larry Summers would be a good Federal Reserve chairman because he is a good “crisis manager” (he is not):

“Summers knows how to manage a crisis. This White House is particularly attuned to the idea that the economy can fall apart at any moment. Summers, they think, knows what to do when that happens. He was at the center of the Clinton administration’s efforts to fight back the various emerging-markets crises of the 1990s (remember “The Committee to Save the World”?). He was core to the Obama administration’s efforts to fight the financial crisis in 2009 and 2010. Few people on earth are as experienced at dealing with financial crises — both of the domestic and international variety — as Summers.”

What is wrong with this argument?

The key problem with is argument is that the assumption is that crisis is a result of the market economy’s inherent instability and that the regulators’ and the central bankers’ role is to somehow correct these failures.

There is no doubt that central bankers like this image as saviours of the world. However, history shows that again and again we are in fact talking about firefighter arsonists – central banks again and again have caused crisis and afterwards been hailed as the firefighters who flew in and saved the world.

Just take what have happend in the past three years – we have seen a unprecedented in the US money supply and other central banks have been happy to copy the inflationary policies of the Fed. Predictably we have have the highest inflation in the US and Europe since the early 1980s.

And now as the Fed is trying to undo it’s own failures it is likely in the path to tighten monetary policy too much and in the process financial institution that have been benefitted from the excessive growth in the money supply are now getting into trouble…and the Fed is now leading the effort to bailing out these institutions.

Furthermore, describing central bankers as crisis managers and firefighters exactly defines monetary policy as first of all a highly discretionary discipline. There are no rules to follow. A crisis suddenly erupts and the clever and imaginative crisis manager – a Larry Summers, Janet Yellen or Jerome Powell style person – flies in and saves the day. This is often done with the introduction of enormous amounts of moral hazard into the global financial system.  This has certainly been the case during the Great Recession and it was certainly also the case when Summers was on “The Committee to Save the World”.

Did the “The Committee to Save the World” actually save the world or did it introduce a lot more moral hazard into the global financial system?

We don’t need crisis managers – we need strict and predictable monetary policy rules

We need to stop thinking of central bankers as crisis managers. They are not crisis managers and to the extent they try to be crisis managers they are not necessarily good crisis managers.

As long as there is a monopoly on money issuance the central bank’s role is to ensure nominal stability and act of as lender of last resort. Nothing more than that.

To the extent the central bank should play a role in a crisis it should ensure nominal stability by providing an elastic supply of money.

Hence, in the event of a drop in money velocity the central bank should increase the money supply to stabilize nominal GDP.

Second, the central bank shall act as lender-of-last resort and provide liquidity against proper collateral.

Those are the core central bank tasks. Often central banks have failed on these key roles – the Fed certainly failed on that in 2008 when the Primary Dealer system broke down and the Fed effectively failed to act as a lender-of-last resort and allowed money-velocity to collapse without increasing the money base enough to offset it.

On the other hand the Fed got involved in tasks that it should never have gotten itself into – such as bank rescue and credit policies.

A stable monetary and financial system is strictly rule based. There should be very clear rules for what tasks the central bank are undertaking and how they are doing it. The central bank’s reaction function should be clearly defined. Furthermore, bank resolution, supervision and enforcement of capital requirements etc. should also be strictly rule based.

If we have a strictly rule based monetary policy and rule-based financial regulation (for example very clearly defined norms for banking resolution) then we will strongly reduce the risk of economic and financial crisis in the first place.  That would completely eliminate the argument for central banking firefighters. Public Choice theory, however, tells us that that might not be in the interest of firefighters – because why would we need firefighters if there are not fires?

Finally let me quote Robert Hetzel’s conclusion on the Asian crisis from his book on the history of the Fed (pp 215):

“…market irrationality was not the source of the financial crisis that began in 1997. The fundamental source was the moral hazard created by the investor safety net put together by the no-fail policies of governments in emerging-market economies for their financial sectors and underwritten by the IMF credit lines. The Fed response to the Asia crisis would propagate asset market volatility by exacerbating a rise in U.S. equity markets”

Hence, the firefighters created the conditions for the Asian crisis and following stock market bubble. And we should remember that today.

Because central bankers over the past year years (actually since 2008) have acted as discretionary firefighters (the Larry Summers playbook) they rather than acting within a rule based monetary policy framework might instead very well have laid the foundation for the next crisis by further increasing moral hazard problems in the global financial system.

Paradoxically enough central bankers have been extremely reluctant about doing what they are meant to do – ensuring nominal stability by providing an elastic money supply – but have happily ventured into credit policies and bailouts.

PS Given the discussion some might be wrongly led to conclude that I think monetary easing is the same as moral hazard. That, however, is not the case. See a discussion of that topic here. Easing monetary policy when monetary policy has become too tight to ensure the central bank hits its nominal target is not moral hazard. Instead that is proper monetary policy.

I am fully aware of what is going on in the world as we have moved from an inflation crisis to a bank crisis, and I have shared my views on social media. You can follow me on LinkedIn (see here) or Twitter (see here) to stay updated.

I will also share my views on the implications of the bank crisis and how it will play out in the near future. However, today, I want to share a bit of information regarding what the US money supply is telling us about the “tightness” of US monetary policy. This is highly relevant for understanding the ongoing banking crisis.

Back in January, I wrote a post about my P-star model and what it was telling us about the outlook for US inflation.

In that post, I argued that as a consequence of the monetary tightening implemented by the Federal Reserve during 2022, it was likely that inflation would drop sharply during 2023 (remember, monetary policy works with long and variable lags…).

In my post, I presented two scenarios for the growth in the US money supply – a hawkish and a dovish scenario. See the graph below.

In the hawkish scenario, I assumed that US M2 would continue to “flatline” as it has done through 2022 for some time to come, so M2 would return to the pre-2020 trend in M2.

In the dovish scenario, I assumed that enough was enough, and that the Fed would ease monetary policy from the beginning of 2023. Therefore, the growth rate of M2 would return to the pre-2020 growth rate (comparable to 2 percent inflation in the long run).

I used these two scenarios to simulate the future US inflation rate. The graph below shows these two scenarios.

In the dovish scenario, we would see a benign return to 2 percent inflation in the next couple of years.

However, in the hawkish scenario, we would see a sharp drop in inflation that would continue into 2024 and cause inflation to significantly undershoot the Federal Reserve’s 2 percent inflation target. Therefore, in the hawkish scenario, monetary policy would become too hawkish, which would likely cause a large US recession. Additionally, in that kind of scenario, financial distress and a banking crisis would become more likely.

Back in January, I wrote the following about the likelihood of each scenario:

“The most likely scenario is probably a combination of the two scenarios, where the Fed is likely to follow a stop-go or go-stop policy. Hence, with inflation likely to drop significantly in the next 3-4 months, the Fed is also likely, in that period, to end its hiking cycle and gradually start to re-accelerate money supply growth.”

Therefore, I didn’t argue which of the scenarios was more likely, but today we can compare the development in M2 since January to the two scenarios.

The graph below shows the development in M2 and bank deposits in the US:

Bank deposits, of course, are a significant part of the total money supply, and I am here showing the weekly deposit numbers. The latest observation is March 8.

So judging from the deposit numbers, M2 has continued to drop in the first quarter of the year – likely around 2 percent compared with Q4 2022. This is the fastest contraction in M2 quarter-to-quarter at any point since the Fed initiated its monetary tightening in 2022 (effectively already in the latter part of 2021).

Said in another way, the Fed has stepped up monetary tightening just as it looked like the effects of the monetary tightening in 2022 were about to set in.

If we compare this to the two scenarios I presented in January, monetary policy has turned even more TIGHT than what we assumed in the hawkish scenario.

Consequently, it now looks like inflation will drop even faster than forecasted in the hawkish scenarios.

I haven’t done a new “super hawkish” scenario and not a “super hawkish plus bank crisis” scenario, but it is pretty clear that monetary policy in the US has become far too tight and it is hard not to see the banking crisis that has been playing out globally over the past two weeks in the light of this, and I might say that there are some eerie similarities between what is happening now and what happened during the summer of 2008.

The task of the Federal Reserve is not to save banks, but to ensure nominal stability. In my view, that implies that the Fed should conduct monetary policy in such a way that nominal GDP growth is around 4 percent, which will ensure 2 percent inflation (more or less). To do that, the Fed should ensure that the money supply does not grow too fast (as in 2020-21) or too slowly (as clearly is the case now).

It is therefore time for the Fed to acknowledge that monetary conditions have become too tight.

Another very important message is that the Fed should not become preoccupied with the distress in the banking sector. Rather, the Fed should do its job on monetary policy, and that job is to ensure nominal stability. If the Fed is doing that job well, then financial stability is automatically ensured as well.

I also believe that this means that it is now most likely that the Fed will not hike its key policy rate at its upcoming FOMC meeting later this week. In fact, it is likely advisable to cut rates right now. That said, I would much rather that the Fed communicated a proper nominal GDP level target of 4 percent.

Unfortunately, the Fed failed massively on the overly easy side in 2021-22, so it is now impossible to bring back NGDP to its pre-2020 4 percent trend without a massive US recession and global financial crisis.

The Fed should therefore not try to bring NGDP back to the pre-2020 trend, but rather re-set its implied target NGDP target at a level comparable to the actual level of US NGDP in Q4 2024.

If the Fed announced this week that it would implement a 4 percent NGDP level target and ensure a growth rate in M2 to achieve this, it would first of all prevent inflation from dropping sharply below 2 percent. It would also ensure that there would not be a re-acceleration in inflation, but rather an orderly continued decline, and at the same time, this would clearly stabilize the global financial markets and significantly reduce the risk of further banking problems emerging.

Yes, it is back to the policy recommendations that market monetarists like Scott Sumner, David Beckworth, and I gave back in 2008-9 and have continued to argue for ever since. If the Fed had focused on keeping NGDP on a 4 percent path in 2020, we would not have seen the massive overshooting of the 2 percent inflation target in 2021-22, and we likely would have avoided banking distress. To achieve 4 percent nominal GDP growth, we would likely need to see M2 growth of 6-7 percent year-on-year, given the long-term trend in M2 velocity. But given the likely shock we have seen to money demand on the back of the banking crisis, even higher M2 growth might be necessary for a period, depending on what happens to money demand/velocity in the US.

It is not too late to do the right thing. The Fed can do it this week, but unfortunately, it may not, and therefore, stop-go policies will continue for some time.

Finally, a friendly reminder: In another follow-up post from January, I made a simulation for US interest rates based on an inflation forecast where I took the simple average of the hawkish and the dovish scenarios for inflation. The graph shows that simulation, given what we have seen since March, rates need to drop below this rate path, and it needs to happen faster. The Fed hiked in 50bp steps; it might be forced to cut in 100bp steps.

Contact:

Lars Christensen

Phone: (+45) 52 50 25 06

Mail: lacsen@gmail.com

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