Inflation lags M2 but will it catch up in 2023?
Zooming out, if you look closely at cycles you will see that liquidity (or money as measured by M2) and consumer price inflation are correlated.
You will also see that M2 leads inflation by around 18 to 36 months.
That means M2 is probably a good leading indicator of inflation.
Let’s zoom into the COVID period from end 2019 onwards.
After all of the 2020 monetary and fiscal largesse found its way into the money supply, the net of it was a $6.2 trillion or 40% increase in M2 from $15.5 trillion to $21.7 trillion between February 2020 and February 2021.
Money supply occurred at a cracking pace, representing the largest rate of change in money/liquidity in recent history.
The post-2019 rates of change charted below provide a stark contrast to long-term average M2 creation which appears to be around plus or minus 5% year on year.
The above explains why the recent inflationary response we have seen was a lot more pronounced than it was in the 1970s and the GFC period, when smaller amounts of money were added at slower rates.
But now liquidity is being withdrawn, not added and inflation should follow suit at a similar (faster) pace of decline if the old relationship holds.
PMIs and corporate earnings are coming down. We are seeing an increasing rate of layoffs and average weekly earnings are rolling over despite December’s 3.5% unemployment print making a new low. Supply chains are repairing, but still not fast enough.
If M2 creation/destruction is a leading indicator of inflation and if it leads by 18 to 36 months, we might expect inflation to return to mean as early as this year, or potentially by 2024 (all other things being equal).
This is not a prediction, just an observation and assumes interest rate/balance sheet run-off continues and that we do not see droughts, wars, pandemics and similar swans that could lead the Fed to review its current strategy.
See you in the market.
Mike