Does The Federal Reserve Have A Reflation Problem?
By James Picerno | The Milwaukee Company | jpicerno@themilwaukeecompany.com
The recent return of year-over-year growth in broad money supply marks a normalization process. But in the context of potentially reflationary factors brewing for 2025 from various sources, the outlook for ramping up money supply growth could be ill-timed for the central bank’s plans to manage inflation pressures.
M2’s 2.6% annual increase through September is modest by historical standards, but the rising tide appears on track to persist in the near term, based on recent upside momentum. That by itself isn’t an issue, except that other reflationary factors could be brewing for the year ahead.
The Trump 2.0 economic-policy agenda is expected to prioritize sharply higher tariffs, tax cuts, deregulation and deporting millions of immigrant workers. It’s unclear how aggressively the incoming administration will pursue each of the items on its agenda, but economists advise that the overall mix is expected to be inflationary in some degree. Add in growing concerns about rising government debt (another inflation risk), and it’s clear that the threat of firmer pricing pressure may be lurking. As a result, the Federal Reserve’s policy of reviving money supply growth and cutting interest rates could face stronger macro headwinds in the months ahead.
Comparing M2 money supply (advanced 12 months) vs. the annual change in consumer inflation reminds that a neutral policy bias still appears to prevail (see chart below). That is, the annual change in M2 (2.6%) is matched with CPI’s change (2.6%). The sharp disinflationary gap that prevailed for much of the past two-plus years, in other words, has faded and looks set to flip to a reflationary bias (M2 rising faster than CPI). To the extent that M2’s trend continues to rise, this implied forecast for CPI suggests that reflation risk is rising and that the Fed’s 2% inflation target may become increasingly vulnerable.
It’s debatable how much of a factor M2 will be for inflationary pressures in the New Year. Much depends on how the various Trump 2.0 policies evolve. Another key factor is whether Congress and the White House make an effort to manage the government’s deepening budget deficit. The US economy’s strength will play a key role as well.
Meantime, the Fed’s recent preference to pump more liquidity into the economy in relative terms could be challenged once the new administration is up and running. On that note, the upcoming Fed policy announcement and press conference on December 18 deserves close attention. The central bank will publish new estimates of economic and inflation data, which will provide fresh clues for deciding if the Fed is considering a possible course correction in 2025.
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