State of Play (May 21)

Money growth slows

Early in June, I wrote “State of Play (April 21)”. I will turn that into a monthly fixture in order to gauge how the economy is progressing, especially given the inflation worries that are prevalent.

This “series” will likely disprove the “conventional wisdom” about the “long & variable lags” of monetary policy. An example:

In “The US Economy has an Inflation Problem”, Desmond Lachman writes:

If there is one thing that we know about monetary policy, it is that it operates with long and variable lags. This makes today’s Fed inflation denial all the more regrettable. By the time the Fed gets around to dialing back its currently ultra-easy monetary policy stance, the inflation genie is all too likely to be well out of the bottle.

The chart illustrations will be mostly the same in every issue, providing an easy to “read & follow” map.

I start with the “Thermostat” chart. To simplify, the “thermostat” is the Fed (money supply growth), that works to keep the “inside temperature” (NGDP growth) stable by offsetting changes in the “outside temperature” (velocity).

Looking at the area between the two bars, NGDP growth rises because money supply growth falls by less than the rise in velocity. In May, while velocity remains put, money supply growth falls, so NGDP growth recoils.

To what level of “warmth” has this heating up of aggregate nominal spending taken the economy? From the levels charts, we see that in terms of aggregate nominal spending (NGDP), the economy is back to the trend level path that prevailed post GR.

However, likely due to supply bottlenecks, “real warmth” still remains stuck below post GR level path (and far below the pre GR path).

With the level of “real warmth” (RGDP) “stuck” due to (temporary) supply bottlenecks, the Fed did well in restraining money supply growth. This helped contain the rise in inflation as illustrated in the next chart.

From the circles, you note that when the difference between NGDP & RGDP growth falls considerably, as in the start of the pandemic, inflation is pushed down. Now, when the difference rises, so does inflation. In between, with the difference stable, inflation is also stable.

The Fed still wants to take the economy to a higher level of warmth than the one that prevailed before the pandemic. It has to take care not to try to speed it up while supply constraints are in effect. It appears that money supply growth has fallen again in June (probably below 4%). If velocity remains “well-behaved”, this should work to constrain increases in inflation.

In 30 days I´ll have another evaluation.

PS As William Salter puts it in “Enough about interest rates

But for ordinary Fed policy, strategy, and announcements, keep your eye on money supply and demand. That’s where the action is.