The first chart compares the growth rate in the liquid money supply — economists refer to this as M2 — in the U.S. economy to the growth rate in the Consumer Price Index. I have shown this type of chart before, but the recent trends are so dramatic that it bears watching on a regular basis. Personally, I can't take my eyes off it.
As I pointed out last fall, never before has there been such a massive increase in the M2 as there was in response to the mandated shutdown of the economy. Such an increase is the very definition of inflation. The money supply was inflated by the institution in control of the currency: the U.S. Treasury. This in turn resulted in a sharp increase in the Consumer Price Index.
In hindsight, I will say that the federal government was too zealous in its efforts to stimulate the economy during the pandemic, but that is a debate I will leave to future students of economics. My desire is to offer some insight into the future business conditions for companies in the plastics industry. Here again, the near-term trend in the M2 data offers some clues.
The top chart shows the decline in the growth rate of the M2 has been just as severe as the recent jump. In fact, the growth rate in M2 so far in 2023 has been negative. Through the first quarter of this year, the M2 indicates the money supply in the U.S. economy has deflated by 2.5 percent when compared with the first quarter of last year. This is shown by the downward sloping line at the end of the second graph.
There has never been a 12-month period in my lifetime in which the money supply in the U.S. economy actually contracted when compared with the previous year. Based on my current reading of the slopes of the lines on these two charts, it appears quite probable that could happen this year. Now, just because something has never happened before doesn't mean the sky is falling if it does. But the fact I have never seen it before raises my level of alertness. Like I said, these charts have my attention.
I have included on the second chart a trend line representing the trajectory of the growth in the M2 prior to the pandemic. That slope was the result of a reliable 2 percent average annual growth in pace of inflation. The bubble indicated by the area above the trend line and below the graph during the past three years represents the trillions of dollars of inflated money supply that the economy is currently trying to digest.
If all goes well, the lines on the second chart will gracefully converge at some point in the future. To my eye, a smooth landing could happen in about a year. A faster intersection in these lines could happen if the slope in the M2 line accelerates downward, but that is not an outcome I prefer. That would indicate a rapid increase in the pace of deflation. That could get ugly. We want money to flow smoothly, and we want credit to be available for the purposes of sound business management and expansion. We just want a gradual slowdown from the pace of the last three years so that we can return to price stability.
In order to achieve this, I expect the Fed will hold interest rates where they are for another year or so. If they feel the need to raise them again, then it will mean the pace of inflation is not progressing downward in an orderly way. That is no good. But I am not advocating a near-term reduction in rates either, because that will indicate there is a problem such as a sharp contraction in the economy or a financial market crisis. I don't want that either.
For now, I am inclined to stay patient but vigilant. I think I have a pretty good feel for the visible trends. There are headwinds, but nothing to justify more dramatic action just yet. But please don't think I am getting complacent — we are still in uncharted waters. And, oh yeah, this outlook could be totally invalidated by Congress in as little as a few weeks.
