US monetary policy has become too TIGHT – the Fed risks significantly UNDERSHOOTING it’s 2% inflation target

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.


Lars Christensen

Phone: (+45) 52 50 25 06


For booking of speaker engagements see my speaker agency (both Danish and international) here.

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1 Comment

  1. Wouldn’t you have to assume that monetary policy works with long and variable leads, or otherwise abandon any notion of efficient markets and rational expectations?


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