M2/GDP Tells Us About Inflation

The money supply measure known as M2 has still been growing, but not as fast as GDP.  The net result is that the ratio of M2/GDP has continued to shrink since its peak in June 2020 during all of the Covid Crash hoopla.  Why that matters is the subject of this week's chart.

A couple of months ago, I heard economist Steve Hanke talk about this in an interview.  Hanke is Professor of Applied Economics at Johns Hopkins.  He noted that there is a 23-month lag between changes in money supply and how that shows up in the inflation data.

There is a lot of merit to that observation, although it is not perfect.  If you are expecting perfection in any economic relationship, then you are in for a lifetime of disappointments.  There are events which come along and disrupt that nice relationship.  Back in 2008, the commodities bubble had a blowoff and subsequent crash, affecting inflation especially via effects on crude oil prices.  But then things got back to normal.

The Covid Crash in 2020 was definitely abnormal, but the inflationary response pretty well followed the message of M2/GDP.  The latest CPI data have the 12-month rate of change down to 2.5%.  And the fact that the M2/GDP ratio has continued falling means that we should expect to see a further drop in the CPI inflation rate.

The chart above only looks at data since the year 2000, but this phenomenon has been working for longer than that.  Here is a chart showing the 40 years prior to 2000.

Here again, some exogenous events have bent the CPI plot, temporarily.  The Persian Gulf War in 1990-91 saw oil prices temporarily double, and then collapse back down again.  That spiked up inflation rates in a way that the M2/GDP plot did not know about 2 years earlier.  We can forgive the M2/GDP ratio for not knowing about Saddam Hussein's war plans.

This same M2/GDP ratio also gives a leading indication about what the prospects are for the shipping industry, albeit with a different lag time.

Cass Information Systems gathers data on the shipping industry.  The 12-month rate of change on their "expenditures" index has been negative rolling basis since February 2023.  That matches the drop in the M2/GDP ratio, although the recent rebound in the Cass Freight Index data to a less negative reading is a bit more robust than called for.  The continued drop in the M2/GDP ratio says that we should not yet start looking for great things for the shipping industry for another year at least. 

That message for the freight industry implies continued economic pressures on the economy generally.  And the 23-month message for inflation says falling inflation.  So there is going to be lots of permission within the economic data for the FOMC to cut rates.  How fast the FOMC recognizes that is a separate question.