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The Monetary Surge Continues to Ebb

June 30, 2022

I have been telling you to watch the M2 measure of money to understand whether inflation will cool down or heat up. The Fed only releases this data monthly.

Today the Fed released May data on the M2 money supply and from my point of view, it was welcome news, signaling that the monetary surge propelling US inflation numbers to a four-decade high seems to be slowing. The amount of M2 money in circulation rose just 0.1% in May (after falling in April).

However, high inflation is likely to linger. The M2 measure of money grew at an 18% annualized rate in 2020-21, or roughly three times the "normal" rate, and it will take multiple years for the US economy to fully digest all that excess purchasing power even if the money supply slows in the year ahead. If the Fed really does want to achieve a soft landing for the US economy, the best option in our opinion is to somehow keep M2 growth at a below-trend rate in the 2-4% range for the next few years.

With the Fed having stopped expanding its balance sheet, there is still no guarantee that M2 will continue to decelerate. The only way to truly slow down the growth rate of M2 is by holding back loan growth in the private banking sector.

Unfortunately, simply raising short-term interest rates may not work. With so many excess reserves in the system, will banks just accept what the Fed is paying? What rate is high enough for them to slow lending, or even reverse it? Or will the Fed increase the burden of capital requirements and liquidity ratios to constrain banks? No one, not even the Fed knows how all this works in a world of overly abundant reserves. I will keep watching M2...but, at least for the moment, things appear to be moving in a direction that will bring down inflation in the years ahead.

In addition, I am seeing signs that oil prices may be heading lower in the months ahead, which is obviously good news for inflation. Keep reading these commentaries as the news is beginning to turn positive for the markets. I still believe that the markets will rally before the end of the year. Stay positive and enjoy the summer.

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