A woman counts U.S. dollar bills.
Marcos Brindicci | Reuters
With the Federal Reserve and Congress pushing stimulus efforts to new heights, some investors are keeping a close eye on a surge in the U.S. money supply for signs of inflation’s long-awaited return.
With a litany of metrics showing rapid growth in the value of money waiting in banks and other liquid accounts, investors from Ray Dalio to Paul Tudor Jones have warned that the era of tepid price rises may be coming to an end.
“It’s fair to say we have never observed money supply growth as high as it is today,” Morgan Stanley chief U.S. equity strategist Mike Wilson wrote this week.
The “Fed may not be in control of Money Supply growth which means they won’t have control of inflation either, if it gets going,” he added.
There are several different ways economists measure the size of the U.S. money supply that are generally classified with the letter “M,” such as M0, M1 and M2.
The broad M2 measure includes cash, checking deposits, savings deposits and money market securities. Because of its wide definition, economists and investors tend to watch changes to the M2 supply as an indicator of the total money supply and future inflation.
More money, more inflation?
As underscored by Wilson, the year-over-year percent change in the M2 supply is now north of 23%. To put that in perspective, year-over-year growth in the M2 money supply had never exceeded 15% until 2020, according to Fed records dating back to 1981.
Normally characterized by slow, steady growth, the M2 supply has grown 20% from $15.33 trillion at the end of 2019 to $18.3 trillion at the end of July.
“The risk of higher inflation may be greater than it’s ever been, too,” Wilson wrote. “While this hasn’t shown up in back end rates yet, the very sharp move higher in breakevens [bond market inflation expectations] and precious metals suggest higher inflation may be on its way.”
That seemed to be the opinion of longtime hedge fund manager Paul Tudor Jones, who in May said that his concerns over inflation and dollar depreciation prompted him to invest in both bitcoin and gold.
Though the differences between bitcoin and gold are many, Wall Street has for weeks chased both assets as hedges against inflation and a relatively safe place to keep wealth during a volatile year.
Gold, one of 2020’s best trades, on Wednesday burst through historic resistance at $2,000 an ounce to reach a new record. Between the Covid-19 pandemic and inflation expectations, gold has gained nearly 35% this year, far ahead of the S&P 500’s 3%.
“If you take cash, on the other hand, and you think about it from a purchasing power standpoint, if you own cash in the world today, you know your central bank has an avowed goal of depreciating its value 2% per year,” Jones said in May. “So you have, in essence, a wasting asset in your hands.”
The source of this M2 expansion and these inflation concerns isn’t necessarily a mystery.
Congress and the Fed have worked in tandem to combat the negative economic effects of Covid-19 with an unprecedented cocktail of fiscal spending, near-zero interest rates and subsidized loan programs.
Those efforts, largely designed to help businesses keep workers on payrolls and ease the impact of layoffs, have been applauded for keeping consumer spending afloat in recent months.
But between a prodigal Congress and an empowered Fed, critics argue that “printing money” to juice the economy could backfire and cause a spike in prices. Banks are still stuffed to the gills with reserves that could, in time, flow into the economy through credit and loans.
“Congress is now the critical player in driving money supply growth with the Fed fully committed to doing whatever it takes,” Wilson wrote. “This is very different from the post [financial crisis] era when aggressive monetary policy was unmet with a willing borrower and spender. We think this poses a greater likelihood for inflationary pressures to build.”
Need for speed
But while an expanded money supply may set the stage for inflation, the relationship between M2 and inflation has been debatable over the years. Some, like PGIM Fixed Income economist Nathan Sheets, said he’s taking a wait-and-see approach.
Sheets, who served in the U.S. Treasury Department until 2017, said investors were also worried about inflation in the aftermath of the financial crisis. Those fears, he said, ultimately did not come to fruition.
“Rates were very low and central bank balance sheets (and money creation) had surged. But the liquidity then sat in the banking system—including as excess reserves at the Fed,” he wrote in an email. “Money creation must translate into increased lending and spending in order for it to be inflationary.”
U.S. Treasury Secretary Steve Mnuchin and White House Chief of Staff Mark Meadows at the U.S. Capitol on Aug. 1.
Stefani Reynolds/Bloomberg via Getty Images
The idea that money creation won’t necessarily generate inflation is centered on yet another economics concept known as the velocity of money.
The velocity of money is, very simply, the rate at which money is exchanged in an economy. High money velocity is usually associated with a healthy economy with businesses and consumers spending money and adding to a country’s gross domestic product.
But the velocity of money can slow during recessions as corporations and families elect to save more of each dollar they earn. Demographic changes, such as an older population, also tend to curb the velocity of money.
According to Sheets, the Fed can go to extreme lengths to flush the economy with cash and bolster the M2 supply. But if businesses and customers aren’t inclined to spend the added dollars, the cash will almost invariably wind up sitting idle, not contributing to GDP or inflation.
That may be a partial explanation as to why the U.S. hasn’t seen headline inflation numbers increase despite the rise in M2 supply in recent months.
The Labor Department’s latest report on core consumer prices showed the index down for a third consecutive month in June for the first time since 1957. The core personal consumption expenditures price index, the Fed’s preferred inflation gauge, increase 0.9% on a year-over-year basis in June, the smallest advance since December 2010.
“Inflation has been held down by some deep structural factors, including aging demographics and high debt levels — which have restrained aggregate demand and pressures on prices,” Sheets wrote in an email. “Workers have struggled to get higher wages, and firms — competing against the so-called ‘Amazon price’ — have had little capacity to raise their prices.”
“My expectation is that these forces are likely to continue on the other side of the virus,” Sheets wrote. “In response, central banks will remain highly stimulative, but hitting 2% inflation targets on a sustained basis is going to be a challenge.”
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