Brent Schutte, CFA, is chief investment officer of the Northwestern Mutual Wealth Management Company.
“Follow the money.” The line made famous in the 1976 movie All the President’s Men is often cited as a way to investigate and uncover truth. And it could just as effectively be used when discussing the primary cause of heightened inflation. Indeed, to paraphrase renowned economist Milton Friedman, the root of inflation is always too much money chasing too few goods. And while COVID brought with it unique and unprecedented economic challenges sparked by manufacturing shutdowns and a surge in demand for goods, the inflation that emerged in the pandemic’s aftermath can be traced back to Friedman’s simple, time-tested observation.
During the past several months, we’ve written extensively about improvements in the “too few goods” side of the equation, noting that supply chain bottlenecks were clearing, delivery times were improving, and inventories were reaching pre-pandemic levels. We’ve also noted that slowing demand would result in fewer dollars chasing goods and services. Meanwhile, members of the Federal Reserve have increasingly focused on what they believe could continue to support too many dollars in the economy — namely, a tight labor market that would result in ongoing upward wage pressures and the relative strength of consumers’ balance sheets.
However, data out last week from the Federal Reserve shows that growth of the M2 money supply (which includes cash, checking accounts, bank deposits and other highly liquid sources of money) is dramatically slowing, which could have a meaningful impact on the staying power of inflation. The updated numbers show that, year over year, the nation’s money supply as measured by M2 is up a meager 1.3 percent, the lowest growth rate since 1995.
Consider this: Thanks to fiscal and monetary policy in the early days of COVID, from February 2020 through February 2021, the M2 money supply ballooned by a record 26.9 percent. For context, during the Great Financial Crisis (GFC) of 2007-2010, M2 year-over-year growth peaked in the early stages of the recession at 10.2 percent and fell back to around 1.6 percent growth during 2010. The relatively modest fiscal and monetary response during the GFC likely helped contribute to a slow economic recovery that consisted of low single-digit annual GDP growth for several years.
Given the tepid recovery in the years following 2010, we believed that when the next economic crisis arrived, policymakers' response would be more robust. When COVID arrived, the economic downturn was steep. However, much as we anticipated, policymakers stepped in with ample liquidity to soften the blow, which led to a lightning-quick rebound. While our expectations were proven correct, unfortunately so, too, were our concerns that the rush of liquidity would result in rising prices. While inflation has proven sticky in 2022, we remain convinced that it will decline in 2023. As we noted in our commentary for the first quarter of 2021 (titled “Descending From the ‘Easy Policy’ Mountain Summit”), we believe increased market volatility will persist as the markets adjust to the continued unwinding of the Fed’s easy money policy. While fears of embedded inflation are beginning to ebb, we expect future volatility will be driven by investors becoming increasingly concerned about the severity of a potential recession. While we believe a recession is likely, we continue to believe it will be mild and uneven given the overall financial strength of U.S. consumers, and that it will give way to rising equity markets in 2023.
While the discussion of M2 may seem like a dry academic exercise, changes in the money supply can have meaningful real-world implications when it comes to inflation. Significant changes in money supply typically show up in inflation readings with a lag. Consider that the growth rate in money supply peaked in February of last year — while the Core Personal Expenditures Index (PCE), which excludes volatile gas and food prices, peaked at 5.4 percent in February and March of this year before turning lower. Likewise, headline PCE climbed to 6.8 percent in March, edged lower over the next two readings and finally peaked at 7 percent in June. None of this is to say the path of lower inflation will correlate in a perfect line with the decline in M2 growth; however, we believe it is reasonable to expect that slower growth in dollars chasing goods should result in lower inflation going forward.
Wall Street Wrap
While the holiday-shortened week was light in data compared to the flurry of reports coming out this week, the releases suggest the economy is either in or on the cusp of a recession. As demand continues to soften, we believe economic pain will be spread unevenly across industries and may be fluid in the coming months, with COVID beneficiaries first to feel the negative effects.
A struggling economy. The latest Composite Purchasing Managers Index readings released by S&P Global suggest the overall U.S. economy is faltering and may be slipping into recession (readings above 50 indicate expansion). The latest figure is down to 46.3 from October’s level of 48.2 and marked the second-lowest reading since the immediate aftermath of COVID. New orders fell at the fastest pace since May 2020, with manufacturers and service providers noting that economic uncertainty, rising interest rates and lingering inflationary pressures are all contributing to weak demand.
While the report suggests growing momentum for an economic downturn, the composite measure of input prices continues to ease as we’ve now marked the sixth consecutive month of falling readings. Likewise, prices charged to end consumers fell for the seventh consecutive month.
Softening employment picture. Initial jobless claims jumped by 17,000 for the week to 240,000, the highest level since mid-August. The Federal Reserve has been focused on the labor market, as it has remained strong even as economic growth has weakened. As we’ve noted in recent commentaries, we believe the underlying strength in the job market is beginning to weaken and expect softer job numbers in the coming months.
The week ahead
It’s a heavy week of economic data this week, with important readings on both the labor and inflation front.
Tuesday: The S&P CoreLogic Case-Shiller index of property values will be out before the opening bell. Home sales and prices have plummeted in recent months as interest rates have climbed in response to the Fed’s rate hikes. We will be watching for signs that prices remain flat or lower, which should translate to declining inflation readings in the months to come.
Wednesday: The Bureau of Labor Statistics (BLS) will release its Job Openings and Labor Turnover Survey report for October. The comprehensive report will provide a clearer picture of the health of the labor market, including job openings and quits data. A tight employment market has been the last domino standing in the Fed’s ongoing effort to rein in inflation. We will once again be watching for signs that the gap between job openings and job seekers is narrowing, which could lead to easing wage pressures for businesses.
The Federal Reserve will release data from its Beige Book. The book will provide recent anecdotal insights into the nation’s economy and could highlight emerging regional economic trends.
Thursday: The October Personal Consumption Expenditures (PCE) price index from the U.S. Commerce Department will be out before the opening bell. This is the preferred measure of inflation used by the Federal Reserve when making rate hike decisions. As with the recently released Consumer Price Index reading for October, we will be watching for evidence that recent trends in forward-looking data are beginning to gain traction in this backward-looking inflation measure.
The health of the manufacturing sector will be in the spotlight today as the Institute of Supply Management releases its latest Purchasing Managers Manufacturing Index for November in the morning.
Friday: The BLS releases the November Jobs Report. As we’ve noted in recent months, a significant gap has opened between its Nonfarm Payrolls report and its other measure of employment, the so-called Household report. We will be looking for signs that the gap is tightening between the two measures. We will also be watching for changes in hourly earnings for workers to gauge the impact of inflation on wages.
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As the chief investment officer at Northwestern Mutual Wealth Management Company, I guide the investment philosophy for individual retail investors. In my more than 25 years of investment experience, I have navigated investors through booms and busts, from the tech bubble of the late 1990s to the financial crisis of 2008-2009. An innate sense of investigative curiosity coupled with a healthy dose of natural skepticism help guide my ability to maintain a steady hand in the short term while also preserving a focus on long-term investment plans and financial goals.