News articles everywhere view vaccines, reopening, and “stimulus” supporting years of growth, fueling enthusiasm. Yes, we likely see strong economic growth as more businesses reopen, but don’t expect it to last. Economic growth is likely to slow closer to the pre-pandemic trend after this initial bounce ends. Most popular forecasts underrate how much the recovery has already occurred and overrated fiscal stimulus’s impact. So, it would not surprise me to see growth trail off during the second half of this year.
Long-term interest rates jumped since the new year started, and its spurred fears (or hopes) of faster inflation and the possible beginning of a bond bear market. Although as I will discuss below, this move seems more about sentiment than fundamentals. Despite the recent upswing, the whole year’s rate moves might remain benign, with rates likelier to fall than rise, including inflation that might never meaningfully materialize.
Interest rates’ Q1 rise has everyone from my neighbor to news anchors watching for hot inflation. Pundits cite rising commodity prices, like oil or lumber. But isolated price jumps are standard—functions of supply and demand. However, inflation is different as it entails rising prices across the global economy. Despite clear pockets of price pressures, inflation signs are sparse worldwide. In the developed world, inflation rates—and therefore interest rates—are tightly correlated due to very few barriers to moving money across borders.
Anyone who asks me about inflation almost always has to hear me discuss a quote from one of my favorite economists, Milton Friedman, “inflation is always and everywhere a monetary phenomenon—too much money chasing too few goods.” There was plenty of evidence supporting his theory, and logically it holds up. But a year has passed since central banks exploded money supply while production capacity remained constrained. We should see signs of inflation based on Friedman’s logic and analysis, yet we have not. This raises important questions about the measurement of money supply and velocity (how often money changes hands). For better or worse, the financial system has evolved dramatically since Mr. Friedman’s day. So, it wouldn’t surprise me if money supply measures are a little outdated, including many things that aren’t money.
In Friedman’s world, M1 and M2 did a good job predicting inflation, but today there are far more tools one could see as money, like those lumped into M4. However, it isn’t clear whether all the ingredients of M3 or M4 are actually used in transactions. M4 rose almost 30% last year, but does that matter (I still unsure)? Remember, monetary policy’s economic effect usually hits at a lag—yet a year after the increase, few signs of inflation exist in broad data.
- M0, or the monetary base, is hard currency in circulation plus bank reserves—money created by the Fed that doesn’t circulate. (Relatedly, it is a myth that the Fed “prints money.” It does no such thing, controlling money supply primarily by expanding or contracting reserves, underpinning bank lending. The term “printing money” is nails on a chalkboard pet peeve of mine)
- M1 is M0 plus checking and demand deposits held at banks and credit unions.
- M2 adds savings accounts, small, short-term C.D.s, and money market funds.
- M3, which the Fed no longer publishes but is tracked elsewhere globally, adds large C.D.s, institutional money funds (including repurchase agreements (REPOs)—effectively IOUs exchanged for short-term bonds, usually between financial firms. Interestingly, REPOs have been used heavily by the Fed in the last few days, which concerns me).
- M4, the broadest measure, adds commercial paper and government debt with less than a year to maturity. In the U.S., the Center for Financial Stability publishes these data. Elsewhere globally, some central banks, like the Bank of England, do.
Why? Because money supply alone won’t determine inflation. It must change hands, chasing goods and services. To gauge this, look to velocity measures. For example, perhaps M4 velocity slowed markedly, offsetting the supply increase. That would surprise most economists, given longstanding theory held that velocity was relatively stable. Regardless, there is currently no way to know M4 velocity measurement. M2 velocity is all we have, and it is near all-time lows, suggesting perhaps velocity did drop significantly.
Another scenario we can consider—we lost significant velocity to lockdowns a year ago, and the added supply temporarily filled the void. It would be a mistake to call this “money supply growth”—a strange twist on Frederic Bastiat’s legendary “Broken Window Fallacy“–replacing something destroyed doesn’t equal actual growth.
Either way, something is different from what Mr. Friedman observed 60 years ago when money supply and velocity were easily measured and widely watched. Hence, basing big inflation expectations solely on increases in the money supply is flawed.
The good news: Inflation is generally slow-moving, so you don’t need an abundance of hints about where it is headed, and stocks are almost always the right vehicle to combat a rising rate environment. My best guess would be sometime around Q4 2021, we might see more evident signs regarding the pace of the economic growth post-pandemic and inflation.
If inflation picks up
Yes, it is worth recognizing that we could be in the early stages of a monetary policy mistake that the Fed is committing, but it is too early to declare with current data. The more often a topic is discussed in the news, the less likely it is to happen (or happen as discussed). Last year, the Fed boosted M2 by over $4 trillion in response to the U.S. economy’s catastrophic and highly costly shutdown. That was fine then, but it’s not fine now. The economy has rebounded, confidence is returning, and the demand for money is consequently no longer increasing; it looks to be decreasing. But the Fed is not reversing its Q.E. in response, so unwanted money is accumulating.
If monetary policy is too easy or too tight, that affects the current and future value of the dollar, and the future thus becomes less certain. An uncertain future inhibits growth by encouraging investors to choose safety over risk assets, enhancing productivity and living standards. Simply put, the dollar’s value could decline precipitously, and rising inflation would be the natural counterpart to a weakening currency. Things may look pretty rosy right now, but over the long haul, there could be problems.