December 12, 2019
Growth in the M-2 measure of the money supply has been steadily slowing and is now growing at a 7.2% pace.
To know whether that rate is too fast or two slow, the Fed needs to look at the relationship between growth in the money supply and growth in nominal GDP. Over the past 50 years the two have grown at almost exactly the same rate. Or, to put that in econospeak, over time M-2 velocity averages about 0.0% but with a lot of variability from year to year. Thus, if the money supply is growing at a 7.2% pace, then the Fed might expect nominal GDP to grow at that same 7.2% pace.
Unfortunately, it cannot determine how much of that growth rate will represent real GDP growth and how much will be inflation. Currently, we think that our economic speed limit, i.e., how fast the economy can grow without giving rise to inflation is about 2.3%. If real GDP grows by 2.3%, then the Fed might end up with an inflation rate of about 4.9%. Having said that, all these numbers can be a little bit squishy and relationships change. The point is that at the moment money growth is currently growing at a pace adequate to support a vigorous recovery and, perhaps, fast enough to trigger an upswing in inflation.