The Federal Reserve left monetary policy unchanged at their January policy meeting. The U.S. economy grew at a 2.3% annualized rate in 4Q24. Another December consumer inflation measure remained elevated above the Fed’s target rate. The FOMC left the policy interest rate (January 29) at 4.25 to 4.50% and continues the pace of Qualitative Tightening through balance sheet run off. Chairman Powell stated in his implementation conference opening remarks, “with our policy stance significantly less restrictive than it had been, and the economy remaining strong, we do not need to be in a hurry to adjust our policy stance.” Futures markets are currently pricing a single -1/4 point cut in June for full year 2025. The Bureau of Economic Analysis reported the Personal Consumption Expenditures price index (January 31) rose 0.3% in December. The core PCE, which excludes food and energy prices, increased a more modest 0.2%. The 6-month annualized rate for core PCE remained flat from prior months at 2.6%. Looking forward, 1Q24 saw a surge in inflationary price increases while 3Q24 was more modest. I expect the full year inflation measures to trend down over the next few months while the 6-month annualized trend should stay closer to 3%. BEA also reported the advance GDP estimate (January 30) for 4Q24 at 2.3% annualized increase. GDP growth matched the final Atlanta Fed GDPNow projection which was recently revised to 2.3% from 3.2% after Private Investment was revised to be substantially negative in the quarter as well as a shift in net exports to deficit from surplus. These weaker contributions were also seen in the BEA report. With the bank quarterly reporting cycle now mostly complete, there are three qualitative themes from 4Q24 results that have me thinking about the impact to the 2025 base case. First, business optimism is noted to have rebounded but that has not translated to increased commercial loan demand. Most of the anticipated loan pick up is focused on 2H25. Second, there is a “Lake Wobegon” effect across the industry in that banks almost universally plan to take market share based on a belief in their “unique culture” and the impact of producer hirings. Finally, deposit gathering does not seem to be constrained as deposit betas and funding cost are freely following the overnight rate lower and then some. As the Fed continues with QT, the plentiful deposit environment seems contradictory. I think the answer may be found in an examination of money supply changes. In the nearby chart, I present the long run view of the Fed Balance Sheet along with the M2 money supply chart. The multi-decade relationship is observed, as well as some clear breaks particularly as balance sheet shocks occur. Also observed is the trend break between the 2 measures in 2023. The 2nd chart presents the same 2 measures but for just the past 4 years. This shorter term view shows M2 trending lower with the initial QT into the liquidity shock of March 2023. After the short term balance sheet expansion, QT was resumed only now M2 broke trend and expanded higher. Around this same time, the general trading level for the U.S. 10-year yield increased from 3.5% to 4.5%. The final chart is the long run view of M2 Velocity. M2 Velocity maintained a fairly tight range of about 1.7 before rising in the mid-1990’s as U.S. fiscal policy briefly went into surplus. As fiscal policy returned to deficit spending velocity returned to longer run averages before slowing dramatically as the Quantitative Easing era unfolded. While still historically low, M2 velocity has been increasing since 2Q22. The increased velocity helps explain money supply expansion amidst QT. What if the monetarists’ Quantitative Theory of Money is correct? Under the equation, a scenario in which V returns to the long run average 1.7 and holding M and Q constant, the price level would increase 22% from today. A 2014 blog post from St. Louis Federal Reserve researchers noted that pre-GFC money velocity had a 17 basis point sensitivity to each 1 point change in 10-year yield. As the 10-year Treasury yield mean reverts to long run averages, should we expect the same with velocity and will the abandoned aggregates of monetary theory provide the directional expectations for its various components? |
