But the Feds change in course heightens the risk of recession.
February15,2023
Also published in The Wall Street Journal Tue. February 14, 2023
We predicted two years ago that inflation would be persistent and rise to the highest levels in a generation. We were right when others werent because we based our forecast on the quantity theory of money, which links asset prices, economic activity and inflation to changes in the money supply. Despite this weeks increase in monthly inflation, we now think inflation is knocking on deaths door and a recession may be on the way.
The dramatic change in our predictions is due to the Feds dramatic change in behavior. In March 2020, the central bank embarked on large-scale asset purchases, which immediately and dramatically accelerated broad money growth. In May 2020, the three-month annualized growth rate of the money supply, as measured by M2, reached 77.2%. By March 2022, M2 had increased by an unprecedented cumulative 41%. Even during the inflation crises of 1973-75 and 1980-82, the increase in money growth didnt approach what occurred in 2020-21.
Inflation usually lags sustained changes in the money supply by 12 to 24 months. Sure enough, by April 2021, headline inflation had increased to 4.2% from 1.5% in March 2020. By March 2022, it was 8.5%.
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Given these data, we extended our forecast in the summer of 2022, writing that year-over-year inflation would end 2022 at 6% to 8% and would fall to 5% by the end of 2023. Excess money balances, which resulted from unbridled money growth in 2020-21, were some 20% greater in the second quarter of 2022 than the multidecade trend line for M2. We assumed that households and firms would spend these excess balances gradually until they hit normal, or on trend, and so inflation would persist.
Instead, the Fed reversed course sharply and households and businesses quickly shed excess money. M2 peaked at $21,739.7 billion in March 2022, and since then has declined to $21,207.4 billion. In the past nine months, M2 has declined at an annualized rate of 3.2%. This flip from expansion to contraction is the steepest adjustment in money-supply growth in postwar U.S. history. Based on 2022s fourth-quarter data, the excess money balances have already declined to only 11.8% greater than normal and that slight bump could dissipate entirely by mid-2023. In other words, were almost out of the inflation woods.
Yet the Fed seems unlikely to ease off contractionary policiesin part because the central bank wrongly focuses on the Phillips curve, which portrays inflation and unemployment as contrary forces. Seeing a tight labor market, the Fed says it anticipates upward inflation pressures to persist through 2023, so quantitative tightening and high interest rates will remain in place until further notice. Given that, we are lowering our forecast for the year-over-year inflation rate from 5% to between 2% and 5% at the end of 2023.
If the Fed doesnt adjust to this reality, it will greatly increase the chances of a recession in 2023.
Steve H. Hanke is a Senior Fellow at the Independent Institute and Professor of Applied Economics and Founder and Co-Director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at Johns Hopkins University.
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John Greenwood, OBE is Chief Economist of Invesco, Ltd.
As someone deeply immersed in the realm of economics and finance, it's evident that the insights presented in the provided article by Steve H. Hanke and John Greenwood are crucial for understanding the current economic landscape. My expertise in this field allows me to dissect the intricate concepts and implications discussed in their analysis.
Firstly, let's address the fundamental principle underpinning their original prediction and subsequent revision: the quantity theory of money. Hanke and Greenwood adeptly utilized this economic theory to forecast inflation levels accurately. The quantity theory of money posits a direct relationship between changes in the money supply and variations in asset prices, economic activity, and inflation. Their successful prediction two years ago, predicated on this theory, demonstrates not only a theoretical understanding but also a practical application of economic principles.
The article delves into the unprecedented actions of the Federal Reserve (the Fed) in 2020, particularly large-scale asset purchases that led to a dramatic acceleration in broad money growth. The three-month annualized growth rate of the money supply, measured by M2, reached an astonishing 77.2% in May 2020. This surge in money supply was unparalleled, even when compared to the inflation crises of the 1970s and 1980s.
The consequence of this aggressive monetary policy became apparent with a lag, as inflation rates started to climb. In April 2021, headline inflation had surged to 4.2% from 1.5% in March 2020. By March 2022, it had risen to a staggering 8.5%. The correlation between changes in the money supply and inflation, with a lag of 12 to 24 months, validated their earlier forecast.
However, a pivotal shift occurred when the Fed abruptly changed its course from expansionary to contractionary policies. This change was marked by a decline in the money supply (M2) at an annualized rate of 3.2% over the past nine months, representing the steepest adjustment in postwar U.S. history. The authors argue that this shift, coupled with the Fed's adherence to the Phillips curve, poses a risk of recession in 2023.
The Phillips curve, a concept the Fed seems to be relying on, depicts an inverse relationship between inflation and unemployment. The Fed's expectation of persistent inflation due to a tight labor market has led to a commitment to quantitative tightening and high-interest rates, despite the rapid reduction in excess money balances.
In conclusion, my comprehensive understanding of economic theories, monetary policy, and historical trends reinforces the significance of the issues raised by Hanke and Greenwood. The interplay between the quantity theory of money, Federal Reserve policy decisions, and the potential economic outcomes highlights the intricate dynamics shaping the current economic landscape.
