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Policy Lags are Real – Inflation’s Days are Numbered

There are several measures of the money supply, the most looked at being M2 (cash + demand deposits + time deposits + retail money market funds). That official series goes back to 1959, although estimates are going back even further. But just looking at this 64-year history, we find that the two growth rate extremes (the high and the low) occurred in the last two years (see chart).

The dashed line shows M2’s growth rate. Note the period of more than a year, especially in 2020, where growth exceeded 20%, peaking at 27% in February 2021 as the Fed monetized the great $6 trillion pandemic cash giveaway by the federal government. Then note on the right-hand side of the chart that M2’s growth has turned negative (for the first time in its 64-year history).

It is widely believed that monetary policy’s economic impact takes time – the conventional wisdom is 12 to 18 months. The year-over-year inflation rate peaked in June 2022 at 9.1%. The solid line on the chart is the rate of change in the CPI lagged 16 months to correspond with the peak growth rate of M2. Note that the falloff in the CPI since June 2022 seems to be tracking closely to the falloff in the M2 growth rate. As this continues,  the negative growth that has already occurred in M2 will push inflation lower, clearly to disinflation, but perhaps to deflation, especially if M2 continues to contract as the Fed continues its Quantitative Tightening (QT) policy.

The Fed’s Two Tools

After being embarrassed by their “transitory” call on inflation, the Fed began its inflation fight on two fronts: 1) interest rate hikes; 2) Quantitative Tightening (selling bonds from their vast portfolio holdings and lowering M2 as the demand deposits of the purchaser are extinguished on the Fed’s balance sheet and therefore in the banking system). From their rhetoric and the discussions in the financial media, it is clear that the Fed and the media believe that rate hikes, not QT, are their primary tool. The theory here is that rate hikes slow down borrowing, impact consumption, and leads to an economic slowdown. No doubt this is occurring, as discussed below. But the Monetarist Economic School (followers of Milton Friedman) would attribute the decline in inflation primarily to the Fed’s QT actions (with a 16-month lag per the chart) and only secondarily to the rate hikes.

The April M2 number continued M2’s contraction (-0.8%), the ninth negative month in a row. The other money supply measures (M1 and the Monetary Base) are also contracting. From this discussion, it appears that inflation will continue to fall over the next year directly as a result of QT, regardless of any additional actions by the Fed.

Those Rate Hikes?

Like the money supply, rate hikes also impact the economy with a lag. They impact by making it more expensive for consumers and businesses to borrow. Again, it appears the Fed thinks this is their primary inflation-fighting tool because they rarely, if ever, discuss the QT process, which has been in place for more than a year.

We drew a chart illustrating a 12-month lag between a rate hike and its economic impact. A year ago in May, the Fed Funds rate was 1%. If the 12-month lag is correct, then that 1% rate impacts today’s economy. If the Recession is already unfolding, think how deep it will be as the other 425 basis points of rate hikes impact the economy over the next year. Of course, we don’t know the lags; they may be more or less than the illustrated 12 months. But indeed, the last few hikes have yet to have their full impact.

Last week, we discussed the hawkish public comments made by FOMC members Logan and Bullard, who seem to advocate for additional rate hikes. The recently released Fed minutes, though, indicate a more measured approach. Those minutes said that pausing doesn’t mean a change in direction but give them time to assess the impact of their prior actions. In other words, many FOMC members recognize the lag, and time is needed to allow for the full impact of the hikes. Still, as of this writing, the market has set the odds of another rate hike at the June 14th FOMC meeting at 71%, with a rate hike in either June or July at 82% and a hike at both meetings at 26%. (Two weeks ago, these odds were all 0%!)

Consumer Bellwether Company Reports 

The San Francisco Fed says there is still $500 billion in excess savings on consumer balance sheets from the free money giveaways. In April, consumer spending rose +0.8% (Seasonally Adjusted), while income only rose half that fast (+0.4%). From recent retailer reports and same-store sales data, spending appears to be weakening.

Lowe’s (LOW) reported its quarterly results last week. We didn’t think their results would significantly differ from that of Home Depot (HD), which reported the prior week, and they weren’t. Same-store sales fell -4.3% from year-ago levels (HD: -4.6%), and, again, like Home Depot, big-ticket items were off sharply. And like their brother, they, too, guided future revenues and profits down.

Another consumer bellwether, Foot Locker (FL), reported pathetic revenue and earnings numbers. They forecast future sales to fall between -6.5% and -8.0%, lowering the earnings by a whopping -40%! Those are significant numbers and indicate that a “soft landing” is probably not in the cards.


While service sector companies still have their heads above water (barely), the manufacturing sector is clearly in Recession. The ISM Manufacturing PMI (Purchasing Manager’s Index) was 47.1 in April, in contraction (below 50) for five months in a row (chart). The shorter workweek and declining overtime hours put the icing on the cake.

Several of the Regional Federal Reserve banks do monthly surveys of manufacturers in their districts. All are showing manufacturing to be in contraction. The Richmond Fed Manufacturing Index for May was -15 (-10 in April) (0 is the demarcation between expansion and contraction). This is the second-worst reading since May 2020. New orders fell to -29 from -20; backlogs scored -32. The workweek showed up as -1 in May vs. +12 in April. That’s a big fall. And all the inflation indicators were relatively tame: prices paid were the lowest since February 2021, and prices received haven’t been this quiet since June 2021.

As a result, it is no surprise that commodity prices have also nosedived due to falling demand in the U.S., China, and most of the world. The table shows the falloff in prices from recent peaks.

Selected Commodity Price Changes, Recent Peak to May 22

CommodityPct. Chg. From Recent Peak
Soybean Oil-47%

Note Copper in particular. In the financial world, some refer to it as “Dr. Copper” because its price movements are often prescient.


The housing sector’s health is also crucial to the economy’s health. As seen from the chart above, existing home sales remain depressed year-over-year. And it’s not a mystery as to why. Rapidly rising interest rates and high home prices have put affordability out of reach for many, especially first-time buyers. Something has to give – either interest rates or prices. Since the Fed says “higher for longer,” it looks like it will be priced. The charts already show they have begun to fall – note that the year-over-year price changes of both new and existing homes are in negative territory, meaning that the median price is lower today than a year ago.

Also, something unique is happening. Because most homeowners are locked into a low mortgage rate (obtained during the decade-long low-rate period beginning in 2012), they can’t afford to sell and move. Just trading sideways would cause a doubling or even tripling of their monthly mortgage payments (prisoners in their own homes?). As a result, there is a death of existing home inventory. Because of that, homebuilders are seeing some unexpected demand. As seen from the charts, the prices of both new and existing homes are falling. We think this is just the beginning.

Final Thoughts

As we write, the debt ceiling standoff continues. Very short-term Treasury yields have spiked higher, rewarding those willing to bet that there is no default. We don’t believe there will be a default; perhaps a deal will be reached when you read this. Once there is a deal, those short-term rates will return to earth.

The upcoming Fed meeting will give us better insight into how closely they watch the incoming data. The recently released PCE (Personal Consumption Expenditure) deflator was slightly hot, with both core (ex-food and energy) and headline numbers for April up +0.4% over March. The year-over-year numbers were +4.7% and +4.4%, respectively. The problem is that headline PCE was +4.2% in March, and now it’s 4.4%. This gives fuel to the FOMC hawks.  

Once again, the minutes from their early May meeting indicate a lot of sentiment for a “pause” to allow the past hikes to work their way through the system. We think this is the best and most logical choice. Nevertheless, recent rhetoric shows that such sentiment isn’t unanimous. 

As we chronicled at the top of this blog, the fall in the growth in M2, along with a year’s worth of rate hikes, has already brought inflation down. The resulting Recession should finish the job, especially given the lags. We know that the Fed won’t be lowering rates in June or July, nor will they be halting their QT. So, prospects for disinflation are high, and we think we will see deflation in late 2023 or early 2024.

Robert Barone, Ph.D.

(Joshua Barone and Eugene Hoover contributed to this blog)


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