Consumer prices respond to supply and demand of goods and services by consumers. Although the WSJ article below focuses on M2, the money that is spent by consumers is actually M1.
M2 is the U.S. Federal Reserve’s estimate of the total money supply including all of the cash people have on hand plus all of the money deposited in checking accounts, savings accounts, and other short-term saving vehicles such as certificates of deposit (CDs). Retirement account balances and time deposits above $100,000 are omitted from M2.
The Federal Reserve tracks a separate money supply number, called M1, that includes currency that is in people’s pockets or in their checking accounts and savings accounts. The money that is deposited in time deposits and money market funds is not counted in M1. For the Fed’s purposes, this is “near money.” That is, the funds cannot be used as a medium of exchange and they are not instantly convertible to cash.
The article also fails to mention consumer borrowing, the source of most people’s money for large-ticket purchases such as homes, cars, education and medical expenses.
Monetarism Is Back. It May Not Last.
Some on Wall Street predict bad times because of an unprecedented drop in the money supply
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By James Mackintosh, The Wall Street Journal, Updated Oct. 6, 2023
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The supply of money—the core variable at the heart of monetarism—is shrinking. This suggests the Federal Reserve, Bank of England and European Central Bank have gone too far and bad times are ahead.
The Fed focused on controlling the money supply under Chairman Paul Volcker from 1979, but slowly moved back to concentrating on the price of money, the interest rate.
… A paper by the Bank for International Settlements this year concluded that there’s no link between the quantity of money and inflation when inflation is low. But in a high-inflation regime, [money supply is a near-perfect indicator](Does money growth help explain the recent inflation surge?). Looking at the money supply would have helped economic predictions after the pandemic, not only for individual countries but also when comparing inflation between countries.
“The countries that printed the money had the inflation…
The leap in inflation wasn’t because of monetary policy alone, either; it took off in large part because money was handed out by the government as stimulus. In other words, inflation was due to fiscal, not monetary, policy.…" [end quote]
It’s important to note that Federal Reserve policy (interest rate changes) impacts banks directly. The banks decide on consumer loans. If banks don’t lend low-interest money to consumers but invest in the asset markets, as happened after the 2008 financial crisis, asset markets will rise but not consumer inflation. However, government spending goes directly into consumer hands. This impacts consumer inflation.
The Federal Reserve, which controls monetary policy, often works at cross-purposes to Congress, which controls fiscal policy. During the Covid pandemic, both worked together to strongly boost both monetary and fiscal stimulus. This led to inflation in 2022. The Fed has since tightened policy by raising the fed funds rate. Emergency government spending has been phased out but large deficits are still providing fiscal stimulus.
M1, money that can be immediately spent by consumers, is still very high (compared with historic levels) even though some of the Covid bonanza has been spent. M1 has dropped slightly since Jan 2022. Household income is at a record high and still rising. Personal savings dropped as the stimulus money was spent but is now rebounding due to the strong job market. Personal Consumption Expenditures and Consumer debt are both at a record high and still rising.
“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output,” Nobel Prize winner Milton Friedman wrote in 1970. Quotes of this sentence often omit the critical second part. If supply rises as fast as demand there will be no price inflation, even if the money supply rises.
As Covid-driven supply chain problems gradually resolve, supply of some goods will meet demand and prices won’t rise. However, most of the U.S. economy is services, not goods. With a constrained labor force and spreading strike activity, price inflation in many services could drive overall inflation.
Will a slightly falling money supply impact this strongly, given growth in income, borrowing and expenditures?
I don’t think so. I think that inflation will last longer than people expect. A recession that leads to layoffs and lower income would stop inflation. Not before.
Wendy
