After 10 consecutive rate hikes and 500 basis points of total tightening, the Fed paused in June, reserving the right to resume raising rates later if necessary. This was expected considering the recent stress in the banking system immediately following Silicon Valley Bank’s collapse. We argued that tighter lending standards industry-wide would impact overall liquidity just like several additional Fed hikes would, so this was a good time to pause. Whether we’ve seen the last hike in this cycle depends on upcoming inflation data. Many point to the resilience of the economy and stubbornly tight labor markets as inflationary culprits, but we think money supply is a much better predictor of inflation, and it has been falling for more than a year.
When fighting inflation, targeting the labor market and worrying about economy strength is in effect “guarding the wrong player.” The far better harbinger of future inflation is what’s happening with the money supply – a measure of total liquid cash and deposits in the system. Historically money supply has grown modestly, but it rocketed higher in 2020 and 2021 as the government flooded the system with liquidity to offset hardships and supply dislocations caused by the pandemic. This fueled the sharp increase in inflation during and since the global reopening.
The money supply peaked in March 2022 as the Fed began fighting inflation, and it has been steadily declining since. This is the key to bringing inflation down towards the Fed’s target and why the Fed is likely at the end of this tightening cycle. The latest readings on CPI and PPI were 2.97% and 2.42%, respectively, after both spiking to over 9% in (not coincidentally) March of 2022.
It is wrong to assume that economic weakness and/or employment slack is necessary to win the war on inflation. By now, enough time has passed since the most aggressive hikes last summer to account for any lags in monetary policy, and yet the economy remains very strong. At the same time, the Fed is successfully getting inflation under control by shrinking the money supply. Using money supply as the better inflationary predictor reconciles this lower inflation data with ongoing labor/economic strength. The Fed’s track record on engineering soft landings isn’t great, but stock market gains this year suggest that it might just pull it off this time.