Economic Predictions Are About As Reliable As Forecasting the Weather
May 1, 2023
By Anders Staxen
Imagine standing on a mountaintop, gazing out at the endless expanse of clouds stretching out before you. As seen in the Midwest, the weather can be unpredictable and change at a moment's notice, with clear blue skies giving way to thunderstorms in an instant. Just like the weather, the economy can be unpredictable, with inflation and interest rates rising and falling without warning. It's no wonder that economists like Milton Friedman turn to fundamental theories to understand the complex and ever-changing nature of the economy. Join me as we delve into the Quantity Theory of Money and explore how recent monetary and Gross Domestic Product (GDP) reports from the Federal Reserve are shaping the future of the economy.
The Quantity Theory of Money
Around 60 years ago, Milton Friedman, a Nobel Prize-winning economist, said that “inflation is always and everywhere a monetary phenomenon.” In a time with high inflation, rising interest rates, and buzzwords like quantitative easing and tightening, perhaps a look back to understand what Friedman meant could be valuable. However, in order to understand Friedman’s statement, we need to dig up the old economic textbook and go all the way back to Irving Fisher and the Quantity Theory of Money.
The Quantity Theory of Money is a framework used to explain price changes in relation to the supply of money in an economy and looks like the following equation:
Where M is the supply of money, V is the velocity of money, P is the price level, and Y is the economic output/Real GDP. Over time, the velocity of money, V (the rate at which money is changing hands), is assumed to be stable which means that the money supply, which measures the total amount of money in circulation in the economy, is the dominant variable on the left-hand side of the equation. On the right-hand side of the equation, upward changes in the price level, P, is what we see as inflation.
But what can these two old economists tell us about today’s economic environment?
Money Supply Report
On Tuesday, Apr. 25th, the Federal Reserve (FED) published the money supply numbers for March 2023 in which the supply of money (M2) dropped by just over 4%, the largest yearly decline in M2 ever - or rather since 1960, when the current measurement of M2 began.
If we look at the real monetary growth, the decline came in at 8.6% year-over-year. While it is natural for the FED to increase the interest rate and lower the money supply when the economy faces a potential overheating (quantitative tightening), the excessiveness to which the FED has tightened the monetary policy illustrates how drastic and historic the last monetary years have been.
But how does this monetary tightening play out in the overall economy?
On Thursday, Apr. 27th, the Commerce Department reported U.S. Q1 GDP numbers which came in at 1.1%, below the 2% estimate as predicted by economists surveyed by the Dow Jones and a significant slowdown from the 2.6% growth seen in Q4 of 2022.
While the economy appears to be slowing, a frequently watched inflation indicator, the Personal Consumption Expenditures price index (PCE) which measures the prices that people pay for goods and services, grew 4.2% and thus exceeded the 3.7% projection, according to the Commerce Department report. Core PCE, a measurement of consumer prices excluding food and energy, increased 4.9%, up from the previous increase of 4.4%.
While one could have expected a steeper decline following the sharp decline in the quantity of money as suggested by the Quantity Theory of Money equation, interventions in the economy often face a time lag before any noteworthy results can be seen. However, the supply of money might be an indicator of future GDP and PCE numbers.
How the Fed Will Interpret These Reports
While the weather might be ambiguous, one thing is certain: both the Money Supply report from Tuesday as well as the GDP and PCE report from Thursday will be taken into account for the upcoming FED meeting on May 3rd. As of May 1st, the general consensus suggests close to a 90% probability of a 25 basis point interest rate.
As we stand on this mountaintop, we are reminded of the sheer power and unpredictability of nature. The same can be said of the economy, which is subject to countless variables and forces beyond our control. Yet, just as we can prepare for a storm by seeking shelter or packing a rain jacket, we can prepare for economic volatility by staying informed and seeking the guidance of trusted experts. At Security National Bank, our wealth management team is committed to helping our clients navigate the ups and downs of the market with confidence and ease. Speak with your Advisor or Investment Manager, and whether you're facing clear skies or stormy weather, we can help you reach new heights of financial success.