There are two macro variables that loom large these days: 1) the amount of money in the economy has exploded, thanks to the Fed’s aggressive QE4 actions, and 2) GDP growth has plunged, thanks to widespread government-mandated shutdowns. When money goes up and economic activity goes down, the result can be described as an increased demand for money (or a reduced velocity of money), which is a typical response to recessions and uncertainty. People tend to stockpile cash during periods of great uncertainty, and—we must NOT forget—they tend to reduce those stockpiles as their confidence returns.
For the past two months we have been experiencing the fastest and steepest decline in economic activity in the history of this country. Estimates of 2nd quarter GDP range from -31% (New York Fed) to -48% (St. Louis Fed). (Note: these are annualized rates of decline.) I’m going to be optimistic and guess that Q2/20 growth will post a 30% annualized decline, which is equivalent to a 6.8% nominal decline. Meanwhile, the M2 measure of the money supply is on track for something like a 50% annualized rate of increase in the current quarter. The following charts show you what these numbers look like:
Chart #1 shows the actual history of these variables and my estimated values of M2 and nominal GDP for Q2/20. The current disparity between the two is historical.
Chart #2 shows the ratio of M2 to GDP, which is a proxy for money demand. Think of it as you would your personal finances: How much cash and cash equivalents do you want to hold as a percent of your annual income? Since the onset of the Great Recession in late 2007, that value for the average person has increased fully 80% (from 50% to 90%). That’s a lot of money being stockpiled, mainly because this has been a rather crazy period in history.
Chart #3 shows the inverse of Chart #2, which can be thought of as the number of times a dollar is spent every year—a proxy for the velocity of money. People today are holding on to their cash like never before.
So M2 has gone way up and GDP has gone way down because the forced shutdown of the economy has caused the demand for money to soar. That’s completely natural and predictable. The Fed has done the right thing by expanding the supply of money in order to accommodate the increased demand for money. The fact that inflation expectations, the dollar, and industrial commodity prices have been relatively stable for the past six weeks confirms that the Fed has accommodated soaring money demand, and has NOT been madly printing money. I’ve made similar arguments
quite a few times in the past on this blog. Quantitative easing is NOT stimulus, it’s a badly-needed remedy for a huge increase in the demand for money.
But what comes next? With increased signs that the economy is reopening and activity is increasing, it’s quite likely that the demand for money will begin to decline as confidence slowly returns. Money that has been socked away in bank accounts is increasingly going to be spent on goods and services. Will the Fed be able to reverse its QE4 efforts in a timely fashion? Will the public’s desire to reduce their money balances lead to rising inflation?
I won’t be surprised to see restaurants reopening with higher prices on the menu. The government will mandate that the supply of restaurant tables be limited (e.g., maximum occupancy rates of 25% and maybe 50%) at a time when many consumers with pent-up demand will be seeking tables. When demand exceeds supply, higher prices are almost inevitable. Especially since few if any restaurants can be profitable at much lower occupancy rates than they have enjoyed in the past—occupancy mandates will force restaurants to raise prices.
But not everything will be supply-constrained. Airlines are going to have a huge surplus of seats for a long time. Hotels will have a vacant rooms galore. Malls and stores won’t be full until the fear of contagion and crowds disappears. But we are already seeing positive signs of improvement which are quite likely to continue.
We’ve seen the worst of the covid-19 crisis. Looking ahead, the 800-lb gorilla that will dominate the economic and financial landscape for the balance of the year will be the need for the Fed to begin to reverse its massive monetary expansion of recent months. Curiously, I see many analysts worrying that a Fed reversal will jeopardize the recovery. On the contrary, I think it would be very worrisome if the Fed did not realize that they need to “tighten” as the demand for money begins to decline.