Inflation data released last week reawakened fears that the Federal Reserve’s massive monetary printing exercise could spark inflation. M2 money supply – a key inflation indicator that measures the total amount of cash in the economy plus checking and savings accounts and money market fund assets – surged more than 20 per cent over the last 12 months, its biggest year-over-year increase on record. Inflation data released last week heightened investors’ concern, as consumer prices, producer prices and import prices staged gains that outpaced economists’ forecasts. Core consumer prices, which excludes food and energy, advanced 0.6%, its highest monthly rate since 1991.
The financial crisis ushered in a new era of policy, replacing one that had relied solely on central banks’ ability to lower rates and spur private borrowing with one that facilitates state intervention through public borrowing. Its main features are higher government deficits and borrowing, enabled by central bank money creation. Low inflation, a critical ingredient, provides political cover. The strategy, initiated in 2009, was fully implemented this year to combat the COVID-19 crisis. US government debt, which was just under 80 per cent of GDP prior to the crisis, is projected to rise from to over 100 per cent of GDP by year end, according to the Committee for a Responsible Federal Budget, a nonpartisan think tank. The Federal Reserve, meanwhile, has created enough reserves this year, over $3 trillion, to fund three-quarters of this year’s anticipated government’s debt expansion. Together, the Fed and the Treasury are backstopping 11 per cent of America’s total stock of business debt, according to The Economist.
History has shown central banks can continue to finance government deficits as long as inflation remains low. A new inflation narrative has emerged, however, involving a combustible mix of supply-chain shortages, government stimulus and pent-up demand that unleashes an upward price spiral once economic restrictions are lifted. Two commodities, gold and oil, support this view. Gold, which on an inflation-adjusted basis this month approached peaks not seen since 1980 and 2011. Historically, gold prices have tended to lead inflation readings by about 18 months. Its recent price action suggests year-over-year CPI could hit 2.5 per cent by Q1/21. The crude oil futures curve implies that spot crude, which is trading at $42.50/bbl today, will be $45.33/bbl, or about 6.6 per cent higher, by the end of next year. Neither commodity is projecting runaway inflation, but is signaling an incrementally higher price trend.
Another critical aspect of monetary policy is central bank independence, allowing the Federal Reserve to raise rates to combat incipient inflation – even if it means harming growth or the financial markets in the short run. Chairman Volcker, in his quest to rein in inflation in the early 1980s, was subjected to opprobrium, particularly from home builders who viewed 20 per cent interest rates as a threat to their businesses. President Reagan, facing an economic recession on his watch, remained silent, bolstering Volcker’s courage to make difficult, but ultimately prescient choices. Central banks are critical enablers under the print-and-spend strategy, while at the same time their ability to remain independent is at risk, particularly when politics is involved. As recently as 2018, Chairman Powell fell victim to harsh criticism on Twitter from former home builder President Trump when he attempted to normalize interest rates.
Today’s bond markets are not concerned about inflation. The 5-year implied inflation rate, as determined by the yield differential between fixed-rate and inflation-protected Treasury notes, is 1.7 per cent, a far cry from the Fed’s 2 per cent inflation target. If bond investors are correct, deficits and money printing could be here to stay as standard policymaking tools. Central banks’ growing role in financial markets reflects commercial banks’ impotence as financial intermediaries, as financial innovation and risk-taking have shifted to shadow banks and capital markets. Today’s banking system is not lending newly printed dollars at a rate that monetary policymakers would like. Lackluster loan demand combined with credit caution among lenders is largely to blame. We estimate that a little less than half of all the newly created money supply is getting stuck in the banking system, attenuating its impact and leaving effective money supply growth at 12.7 per cent. While that is a strong advance, it is not as high as money growth during the financial crisis.
Tight labor markets and persistent wage increases are necessary inflation ingredients. Virtually every episode of inflation historically has been accompanied by wage growth. Wages expanded at a double-digit rate even during the stagflation period of the late 1970s. With the job market crashing and tens of millions of Americans out of work, the possibility of a wage spiral is remote. Citing excess capacity of supply, including labor, Fed Chairman Powell asserted to Congress recently that COVID-19 poses a bigger threat of disinflation than of inflation.
Japan’s central bank was an active user of quantitative easing, adopting a “whatever it takes” approach in 2013 under the leadership of Bank of Japan (BoJ) Governor Kuroda Haruhiko. The country, facing ultra-low growth and a deflation threat, threw everything including the quantitative kitchen sink into its financial system. The BoJ’s monetary expansion efforts sparked an employment boom, but failed to produce price growth. The Federal Reserve, meanwhile, will be taking a more relaxed view of their 2 per cent inflation target, arguing that it’s not an upper bound, but an average. That means that America’s central bank is willing to tolerate higher inflation readings as long as average inflation remains at their target.
The threat of a price spiral presents a serious risk to America’s “don’t-tax-and-spend” policy. An unexpected rise in inflation would force central banks to raise policy rates, undercutting financial asset inflation in their quest to quell price inflation. However, we don’t see imminent inflation risks from our vantage point. That said, two trends would change our view. One, as we described earlier, is Fed independence. The possibility that America’s central bank policy falls under political control would cause us to revise our inflation outlook. The second would be an enactment of Universal Basic Income (UBI). Without passing judgement on the economic benefit of UBI, the possibility of the government handing out freshly minted spending money in an environment of below-market interest rates represents a high-octane blend of inflation fuel. For now, though, let’s not lose any sleep over inflation.