From excessively easy to excessive tight US monetary policy

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.

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1 Comment

  1. Even sticking to the Fed’s own announced average inflation target would have been better than what they did.


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