Investor sentiment has deteriorated rapidly in 2022, and inflation is arguably the largest widely discussed negative pulling down emotions in the current market correction. This excessively dour sentiment creates a wall of worry for upside surprises, led by strong household balance sheets, growing businesses, and improving credit conditions, which will help support the economy going forward.
There seems to be a lot of misunderstanding about what inflation is. Inflation is the change in aggregate prices determined by a basket of goods over a period of time. The key word is “aggregate,” and often, prices of some goods are falling (i.e., electronics) while other goods are rising (i.e., food, oil). This effect can frequently alleviate a price increase in specific items or sometimes wipe it out altogether. So, although food and energy prices are currently elevated, it doesn’t mean inflation will last in the long run. The complicated part is people are hurting in today’s environment from higher energy and food prices (which might stay high for a while), but it looks unlikely to continue over the longer term.
Remember, we must think about inflation in aggregate because the prices of singular goods recorded in the Consumer Price Index can swing widely on a monthly or even yearly basis. But what matters most to an economy is the net effect of aggregate prices. That’s one reason the Fed likes to look at “core” inflation, which excludes food and energy prices because those two items are highly variable and can skew the picture. The Fed even started monitoring the Sticky Price Consumer Price Index less Food and Energy years ago to garner insight on different aspects of the inflation process. “The Sticky Price Consumer Price Index is calculated from a subset of goods and services included in the CPI that change price relatively infrequently.” Because these goods and services rarely change price, they help incorporate expectations about future inflation better than prices that change more frequently.
A year ago, one of the biggest inflation concerns was long-term interest rates increasing and a possible monetary policy error in response to the sharp ~30% increase in M2 during 2020. At that time, I discussed how an increased money supply alone wouldn’t create inflation. Money must rapidly change hands, chasing goods and services (velocity of money) to increase inflation. Thankfully, a year has gone by, and I am happy to report that in April 2022, the money supply declined for the first time since March 2010 (12 years!). The current year-over-year 8% growth rate is the slowest since February 2020 and is likely to continue to decelerate in the coming months. Over the past 3 months, the annualized growth rate has fallen to 1.3%, compared to a year-over-year high of almost 27% in February 2021.
The Fed’s decision to raise interest rates and shrink its balance sheet helps ensure inflation and the aggregate rate of increase will subside and likely prove to be “transitory,” but we need more time to be confident because often, inflation’s response to excess money in the system can take at least a year to materialize.
Is this a win? No. I did not foresee geopolitical factors hindering fuel flows and food from Russia into Europe (and the world), increasing the aggregate price basket costs. The increase in vital food and fuel hurts global consumers badly, but low-income consumers take the most brutal hit. As you might remember, I initially expected inflation to start dropping at the end of 2022 but now expect inflation to remain elevated through most of 2023 due to the war in Ukraine. However, it is still light at the end of the tunnel. Now that the increase in M2 is slowing, money will hopefully be removed from the system through quantitative tightening, allowing us to focus on the velocity of money better. Yes, we should always watch the total quantity of money in the system, but more importantly, we need to monitor how fast it changes hands in the economy.
Just think back to your intro economics in school when they taught: MV=PQ.
M = Money supply.
V = The velocity of money (or the rate at which people spend/lend money).
P = The general price level of all goods.
Q = The quantity of all goods and services produced.
Based on the equation above, holding the money velocity (V) constant (which it never is), if the money supply (M) increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference. But according to this view, inflation in the US should have been about 31% per year between 2008 and 2013, when the money supply grew at an average pace of 33% per year, and output grew at an average pace of just below 2%. Why did inflation remain persistently low? Answer: Declining Velocity.
Declining velocity will likely be a positive factor in decelerating inflation growth, which we witnessed during the Covid lockdowns. Personal saving rates jumped up when relief checks out, but to many people’s surprise, most funds went to pay off household debt—lowering the velocity of money. Additionally, charge-off rates and delinquency rates on consumer loans are at multi-decade lows, likely due to the help of government relief checks. We may also see bank lending stay muted moving forward, which will contribute to slowing the velocity of money.
Remember, purchasing goods was the focus after the pandemic lockdowns, and goods are currently the focal point of inflation. Now that spending habits are normalizing in favor of services, inflationary pressure is easing on goods, which shows in GDP data.
Despite all the naysayers, our current economic situation appears to be on solid footing. Not only did “core” GDP grow in Q1, we have strong household balance sheets, credit conditions are improving (positive yield curve), inflation is slowing, consumer spending is strong, and goods exports are increasing. Not to mention the solid increase of 3.2% m/m in April for oil and gas well drilling, the ISM Manufacturing Index is above 50, corporate earnings and profits are nicely positive, businesses are growing, and consumer spending plus investment in non-residential structures, equipment, intellectual property and housing accelerated to 3.1%.
So, remain positive and bullish in 2022 because data does not broadly point toward a recession or long-term high inflation. Instead, 2022 has built the perfect wall of worry for markets to climb to ascend new heights.
