US Money Supply Looks Set To Switch To An Inflation Bias

The spread continues to narrow between the year-over-year changes in a broad measure of US money supply (M2) less US consumer inflation. As this gap narrows – and if it soon turns positive, which looks likely – the implied forecast is that monetary policy's disinflationary bias of the last several years will shift to an inflationary posture, albeit mildly so.

The current spread is roughly 50 basis points through August. That’s up from a steep 9-plus percentage points at the cycle trough in April 2023, which signaled monetary policy was unusually tight to fight the inflation spike that followed the pandemic.

Policy continues to normalize, in other words, a function of reversing the sharp disinflationary bias that's persisted for the past two-plus years. The reversal is nearly complete and it appears that a mild inflationary stance will resume – a stance that prevailed on the eve of the pandemic.

The expected change in policy bias will be relatively mild, at least for the near term, but it will mark a shift with implications for the economy, financial markets and the outlook for Fed interest rate decisions. If the bias rises fast and far enough, it may persuade the Fed to slow, pause or even reverse interest rate cuts.

Fed funds futures (as of mid-day October 9) are currently pricing in a high probability (84%) for a ¼-point cut in the target rate at the next FOMC meeting on November 7. That compares with a 60%-plus probability estimate for a larger ½-point cut two weeks ago.

There are multiple factors that impact the inflation trend and Fed policy decisions, but money supply is arguably a critical input. To the extent that the monetary policy stance switches to an inflation bias, even mildly so, it will likely be a factor in the central bank’s calculus.