One of the successes the Federal Reserve can tout from the last couple of years (and the list of them is pretty short, to be fair) is that after the unprecedented policy actions during COVID caused never-before-seen rates of money supply expansion, subsequent policy avoided normalizing that explosion.

Year-over-year growth in M2 reached 26.9%. But in 2022, as the Fed started hiking rates and shrinking its balance sheet, the rate of growth slowed until M2 reached its absolute peak in July 2022 and began to slowly decline. As of today’s H6 release, year-over-year M2 has been negative for 13 months in a row.

To be sure, after a massive explosion the level of M2 has not declined all that far as the chart below shows. I also documented this fact back in November in “Where Inflation Stands in the Cycle,” which was really a good piece. You should read it.

So the success of the Fed here can be summarized by saying, ‘at least they didn’t keep blowing up the money supply.’ Since the rise in prices is clearly and closely related to the explosion in the quantity of money we have seen (anyone who still resists this obvious truism after the mountain of recent evidence is added to the prior mountain of evidence), this was a sine qua non for getting inflation back down. It isn’t sufficient, unless it’s continued for a very long time, but it’s necessary. As I illustrated in that article linked to above (which, really, you should read), there are several ways that inflation could evolve from here as the shock to the system gradually unwinds. I’ve talked before about how velocity in the policy crisis behaved as a spring or a capacitor, absorbing a lot of ‘monetary energy’ that is doomed to be released back into the system. Velocity is still rebounding (in Q4, if forecasts for Thursday’s Advance GDP report are accurate, it will rise something like 4% annualized), but if money growth remains negative then that’s really the least-painful way this can resolve. In the last chart from that prior article (have I mentioned it’s worth reading?), slack money growth with decent growth and rebounding velocity is reflected in a movement mostly to the left, with the price level not rising much. Good outcome.

However, that outcome is predicated on the notion that the money supply remains slack. If M2 starts to rise again, then the curve drifts upward and the potential set of outcomes almost certainly involve higher prices. Naturally, I’m mentioning this because of developments that make me concerned on this score.

One thing that I seriously missed in 2022 was the fact that the increase in interest rates helped bring down money supply growth. That’s not at all intuitive, because in general changing the price of a loan tends not to change the demand for a loan by very much – especially when higher inflation is making the spot real interest rate paid by the borrower lower and lower. In other words, I assert with some decent evidence that consumer and industrial loan demand is somewhat inelastic for modest changes in interest rates. Ergo, my belief was that merely raising interest rates would not necessarily cause money growth to decelerate. As it happened, I was saved from my own mistake by the fact that the Fed was also shrinking the balance sheet, which (despite the fact that reserve balances aren’t binding on banks in the current environment, so they are essentially unconstrained in lending) I thought might help money growth to decelerate. Not that I thought we’d keep getting 20% growth, but I didn’t think we would have naturally seen money growth fall below, say, 5%. Fortunately, because the Fed was also shrinking the balance sheet my forecasts were not drastically inaccurate despite being wrongly inspired, and so I forecast 5.1% median inflation for 2023 and we got 5.06%. It’s nice when the ball actually bounces your way.

As it happens, though, for the most part higher interest rates seem to have not affected loan growth very much. C&I loan growth remained strong throughout 2022 and didn’t start to level off until the Fed was just about through tightening, and consumer loans as I expected really only started to level off when the Unemployment Rate started to rise…credit cards, not at all. And that’s because, as I said, most borrowers are not borrowing because they made a NPV calculation that said borrowing makes sense; they’re borrowing because they need to and 1% or 2% or 3% doesn’t really change that calculus very much.

But you know where it did change the calculus a lot? In mortgages. And that’s because a buyer might be reluctant to pay 1% more on a mortgage, but what the buyer also needs is someone who is willing to abandon their awesome loan. As has been noted elsewhere by lots of people, home sales absolutely cratered not because people weren’t wanting to buy but because there weren’t enough people who wanted to sell. So mortgage origination volumes also dried up, as a direct consequence of higher rates. The one large market where interest rates did have a big impact, although not for the reason you’d think, was in mortgages!

You know I wouldn’t say this unless I had a neat chart to show you. Here is the Mortgage Bankers’ Association Purchase index, tracking the volume of new loans for purchasing a home (in black), set against y/y money supply growth, in blue.

Let’s tie this up with a bow:

• Higher rates didn’t affect every kind of loan, but had a big impact on turnover, and thus origination, in one very large loan market: mortgages.
• Lower mortgage origination turns out to have been uncannily correlated with money supply growth. This may or may not be causal, but it at least means that mortgage origination merits consideration as a leading indicator of money supply growth.
• As interest rates have leveled off and even declined some, the housing market is gradually adjusting. We are seeing higher home prices, and mortgage origination has been showing signs of recovering as the chart shows (mortgage origination numbers are released before sales numbers, so expect a rise in home sales coming).
• It is going to be difficult for the Fed to keep the money supply shrinking if origination of new mortgages rises even a little bit. This doesn’t mean M2 is going to skyrocket, just that it is going to stop shrinking (in fact, it has risen each of the last two months).
• If M2 rises at even a sober 5% pace, combined with money velocity that still has some normalization left, it will be extremely difficult for the Fed to hit its inflation target on a sustainable basis for some time.

And what should you do about it, just in case? For starters, read “Inflation Sherpa.”

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