The decline in the U.S. money supply suggests a recession is coming.
Money is the economy’s fuel. When it surges, nominal GDP (real GDP plus inflation) surges. When it plunges, spending plunges. This is what the well-known and robust quantity theory of money, which has been around since the 16th century and was in recent decades championed by Milton Friedman, tells us. It’s also what common-sense, do-it-yourself economics tells us: Substantial changes in the money supply, broadly measured, make the real economy and prices, with lags, go up and down.
Surprisingly, these days, central bankers reject the tried-and-true quantity theory of money. As Federal Reserve chairman Jerome Powell testified during the Fed’s February 2021 semi-annual monetary-policy report to Congress, monetary aggregates, such as M2, do “not really have important implications for the economic outlook . . . that classic relationship between monetary aggregates and economic growth and the size of the economy, it just no longer holds.”
Really? Powell’s statement has no connection to reality. As it turns out, the Fed, since early 2020, has dished up monetary data that presents us with a clear natural experiment. With the onset of Covid, the Fed hit its monetary accelerator, causing M2 to explode, reaching an unprecedented annual rate of growth of 26.7 percent in February 2021. As a result, we predicted in the Wall Street Journal that inflation would surge to 9 percent per year. It peaked at 9.1 percent per year in June 2022. By using the quantity theory of money, we hit the bullseye.
Then, the Fed flipped the switch on its printing presses. Since March 2022, the money supply has been falling like a stone. With that, we altered our inflation forecast. By the end of this year, we forecasted that the headline CPI would fall to between 2 percent and 5 percent. Yesterday’s inflation report showed the CPI had fallen to an annual rate of 3.1 percent. With only one month to go until the end of the year, it looks like the quantity theory of money will deliver another inflation bullseye.
But that’s not all. The contracting money supply means that the economy is running on fumes. And with the normal long lag between substantial contractions in the money supply and changes in economic activity, the U.S. economy is on schedule to tank in 2024. Given the current course of M2’s contraction, we now forecast that inflation will fall below the Fed’s 2 percent target in 2024, and decline further into outright deflation in 2025.
Just how substantial has the Fed’s money-supply reversal been? As the accompanying table shows, there have only been four such contractionary episodes since the Fed was established in 1913. Interestingly, there has not been a contractionary episode greater than the current one since the Great Depression. By rejecting the quantity theory of money and the money supply, Powell and the Fed have given us whiplash: first an unprecedented explosion in M2 and now a contraction that, to date, is already the third largest in the Fed’s history.
And what did the four prior episodes of monetary contraction produce? With a lag, they all produced a recession. It’s time to buckle your seatbelts.
But before doing so, it’s worth asking, why have Powell and the Fed filled our heads with a string of non-monetary causes for inflation? Remember the supply-chain problems and “high” oil prices that the Fed and “team transitory” trotted out to explain why we were feeling the pain of inflation?
Today, they are echoing the same non-monetary narratives, telling us that inflation is weakening because supply-chain disruptions have been repaired and the price of oil has backed off. As it turns out, the reaction of central bankers, as well as their acolytes in the press, to an outbreak of inflation is always the same. They reach for the list of alleged non-monetary “causes” of inflation. You know, it’s not me, it’s the guy behind the tree.
Steve H. Hanke is a professor of applied economics at the Johns Hopkins University and a senior fellow at the Independent Institute in Oakland, Calif. John Greenwood is a fellow at the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise in Baltimore, Md.