Coronavirus Quick Take – June 2, 2021
June 2, 2021
Fifteen months on and COVID-19 remains on people’s minds, even as the virus wanes in most parts of the US. Today, we’ll focus on a previously unanticipated side effect of the pandemic—or at least of the fiscal and monetary response to it—inflation. While those of you who are old enough to remember the 1970s and 1980s will have experience with inflation, younger people have little familiarity with it.
The years since the global financial crisis have been particularly benign on the inflation front. From 2008 through 2020, the US consumer price index (CPI) has averaged less than 1.6% per year. By way of contrast, average inflation from 1970 though 1982 was 7.9%. Recently, inflation has started to heat up again for the first time in years, with the April CPI rising 4.2% over the previous 12 months, the biggest monthly jump since 2008. The natural question is: Does this represent a longer-term trend or is it just a temporary blip?
A little bit of inflation can be good, particularly if it extends to wages. It also makes borrowers’ debt cheaper and thus can put a smile on the faces of homeowners with mortgages. But too much inflation, especially if it lasts a while, can cause all sorts of problems with the economy and the markets. Most susceptible to its negative effects are longer-term bonds, including the benchmark 10-year US Treasury, whose prices fall as interest rates rise in response to inflation.
(To refresh your memory, interest rates have two components: real rates, which reflect people’s preference for a dollar now vs. one later; and an additional component to compensate for inflation. Thus, when inflation goes up, so do interest rates.)
What’s Causing the Recent Rise in Inflation?
The roots of the recent spike in inflation are mostly short term, suggesting that April’s elevated numbers don’t necessarily represent a trend. There are 3 main factors driving today’s inflation:
- Tough comparisons: When the pandemic first hit the US last March and people sheltered in place, demand for some goods and most services collapsed. As a result, prices fell sharply in April 2020. Thus, prices this April are being compared to an unusually low base from a year ago, spuriously “inflating” the inflation numbers.
- Excess demand: There’s more than one-time comparisons at work here, however. With the re-opening of the economy, demand for many services, especially travel, leisure and entertainment, is spiking after more than a year of soft to non-existent demand. Higher consumer demand = higher prices.
- Supply chain challenges: As if spiking demand was not enough, many manufacturers are having production difficulties. Chip shortages, for example, are forcing auto manufacturers to curtail production. As a result, new car inventory is at its lowest point ever, while prices for used cars are shooting upward as impatient consumers opt for the next best thing. Thus, even in areas where demand is relatively normal, tighter supply is putting upward pressure on prices.
All three of the above factors are likely temporary. Demand will gradually return toward normal and supply bottlenecks will ease. For this reason, many economists—most significantly the Federal Reserve—believe that inflation pressures will ease in coming months and recent price spikes are transient. So, nothing to worry about, right?
Not so fast! As you undoubtedly know, the federal government has been spending trillions more dollars than it collects in taxes, financing that shortfall by issuing Treasury debt. Who’s buying all this debt? Mainly, the Federal Reserve. And where does the Fed get all this money? They just “print” it. (In reality, they issue electronic credits to banks that appear on their balance sheets as cash.) The net result of all this money creation by the Fed is a growth in the money supply.
Too Much Cash?
One result of a bigger money supply is lower interest rates, which is the main reason the Fed is creating all this cash. But another potential outcome is higher inflation: when more dollars are chasing the same amount of goods and services, people may be willing to use more dollars to pay for these same items. The result: inflation.
The monetarist economist Milton Friedman famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” In other words, inflation results when there is more money in the system relative to the goods and services available for purchase. Inflation can thus be mitigated by increasing the supply of goods and services and/or decreasing the supply of money.
Since the pandemic began last March, the money supply (as measured by the “M2 money stock”) has increased by nearly 29%. This is a massive rate of increase in just over a year: during the 10+ years since the end of the global financial crisis, the money supply has only increased by 5.9% per year. Thus, if Milton Friedman is right, it certainly looks like more inflation is in our future.
Fast Cash vs. Slow Cash.
But hold on! There’s one other factor at play that Friedman didn’t mention: the “velocity” of money. According to the Fed, the velocity of money measures “the number of times one dollar is spent to buy goods and services per unit of time.” In other words, how often does a dollar change hands. Even if the money supply is high, there isn’t any inflation if the velocity of money is falling—and this measure has been falling since 1997, when it peaked at 2.2 per quarter. (One dollar changed hands about 2.2 times in 3 months.) Today, money velocity is only 1.2, about half its peak.
Thus, even with a large and growing money supply, we’re not likely to see longer-term inflation unless the velocity of money starts to rise, or at least stops falling. Until that happens, the recent inflationary spike is likely to fade when the short-term factors mentioned above start to recede. (Why the velocity of money has fallen so much in recent years is not entirely clear. It may be partly because wealth is becoming more concentrated, and the rich spend a much smaller fraction of their money than the less well off.) You can bet we’ll be keeping a close eye on inflation, money supply and especially the velocity of money in coming months. And so will the Fed.
In a future newsletter, we’ll talk about the effects of inflation on the economy and your investments, and what KCS is doing to protect client portfolios in the event that inflation stays high for a while.
The KCS Investment Department
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