The problem with unwanted money

The demand for money—as measured by the ratio of M2 to nominal GDP—currently stands very near to an all-time, eye-popping high (see Chart #1). The turmoil and fears which characterized the Covid-19 era caused the public to seek out and hold trillions of dollars of extra cash, and the Fed correctly obliged this demand for money and money equivalents by greatly expanding its balance sheet— transmogrifying notes and bonds into T-bill equivalents (aka bank reserves). (I've explained this all in detail over the course of many previous posts.) Conveniently, increased savings on the part of a terrified and sheltering public provided most—if not all—of the money that Treasury borrowed to fund Covid relief spending. 

Chart #1

Chart #2

But as Chart #1 suggests, the surge in money demand has passed. Confidence is returning and the economy is regaining lost ground. It stands to reason that the demand for money should begin to decline, and it has already declined, as we see in Chart #2, driven mainly by a sharp rise in nominal GDP. This is quite likely to continue; the main question going forward is how much of the increase in nominal GDP will be real and how much will be inflation. 

Chart #3

Chart #3 shows the daily volume of airline passengers (white) screened by TSA, with the magenta line being the 7-day moving average. Notice the sharp increase in air traffic in the past two months. Compared to the levels which prevailed 2 years ago at this time of year, air traffic is now down only 40%, whereas at the lows of last April, air traffic had plunged by an astounding 96%. With the rapid pace of vaccinations and increasing signs of optimism, there is every reason to expect air traffic to grow rapidly in coming months and the economy to grow as well.

The resurgent demand for air travel almost certainly is driven in large part by increased confidence. And with increased confidence, the rationale for the public continuing to hold a huge portion of their annual incomes in cash (i.e., the public's demand for money) surely is fading. But since the Fed has taken no steps to reverse its note and bond purchases, the M2 measure of money supply can't simply evaporate. And with the recently passed Covid relief bill, deficit-funding spending is going to ratchet up once again, which could add yet more money to the financial markets, especially since the Fed plans to continue to its purchases of notes and bonds. 

Unwanted money can't disappear, but it can fuel an expanding economy and it can bid up the prices of other assets.

Chart #4

Chart #4 provides some clues as to how this works. The bars represent the current yield on a variety of investments. The green line is the market's expected average annual increase in the CPI over the foreseeable future (about 2.3%); think of that as the average increase in the prices of all goods and services over the next 5-10 years. Owning cash, short-term Treasuries or mortgage backed securities is very likely to give you a loss in terms of purchasing power. On the other hand, yields on real estate trusts, high-yield debt, emerging market debt and the S&P 500 promise to deliver a purchasing power gain. Unwanted money (much of which is held in very short-term investments such as T-bills, bank deposits and 2-yr Treasury notes) will naturally want to seek out the much more attractive returns on just about all other assets. And as prices for other assets rise, their yields will decline. 

This is another way of saying that a tsunami of unwanted cash likely is going to lift the prices of just about everything, and that is another way of saying we are going to see more inflation in the years to come, UNLESS the Fed reverses course. Which they have promised not to do for at least another year and a half. 

Chart #5

Chart #5 shows us the bond market's way of expressing the view that inflation is likely to average about 2.3% per year for the foreseeable future. The difference between real and nominal Treasury yields gives you the market's expected rate of inflation. Note that most of the increase in inflation expectations of late has come from a rise in nominal Treasury yields. Real yields are still very low.

Chart #6

Chart #6 shows how 2-yr real yields on TIPS have a strong tendency to track the growth rate of real GDP over time. That real yields are currently so low means that the market either does not have a lot of confidence in future growth prospects, and/or the market is still very risk averse (meaning that people are willing to pay extremely high prices for the relative safety of TIPS). Going forward, we are likely to see real yields rise as long as the economy demonstrates that it has the ability to grow by at least 1-2% per year for the next several years. 

Chart #7

Chart #7 gives us a long-term view of the evolution of the Treasury yield curve (using 2- and 10-yr yields as the classic reference points for short and long-term interest rates). Bear in mind that short-term rates are heavily influenced by both the Fed's monetary policy target and the market's demand for safe assets. The yield curve has steepened noticeably since last summer, mainly due to rising long-term yields, which in turn have been driven by expectations that the economy will improve enough to allow the Fed to raise short-term rates in the future. This is a healthy development, since very low yields are a sign of a very weak and risk averse economy. There's no reason yet to worry that higher yields will derail the ongoing equity market rally. 

The Covid winter is over

Here are just a few important and very encouraging charts—part of a larger picture in which the US  economy is definitely emerging from its long Covid winter.

Chart #1

Chart #1 shows a critical and timely measure of US air travel, which includes data as of yesterday. The green line is the 7-day moving average, which is the one to watch since there are definite trends in travel on the various days of the week. Here we see that passenger traffic has increased 78% (!!) since January 27th of this year. It's still down over 40% compared to the levels which prevailed before the onset of lockdowns, but the recovery is proceeding rapidly. Looking ahead, we still have a lot of good news to look forward to as confidence is on the rise and vaccinations proceed apace. And by the way, the US stands out as leader of the vaccination pack among developed nations, with the notable exception of Israel, which has vaccinated over half of its population.

Chart #2

My state has been one of the hardest hit (mostly due to extreme lockdown measures ordered by our politicians). As Chart #2 shows, big lockdowns didn't flatten the curve at all last year, since they were firmly in place last November, when daily new cases began to surge. Vaccines have helped, but they can't really account for the bulk of the decline year to date, since it was underway well before significant numbers were vaccinated. That means natural immunity (acquired from exposure to the illness or natural exposure to similar viruses over the years must be a very important factor contributing to the rapid demise of this pathogen. Either way, the severity of Covid cases and the growth of new daily cases has improved dramatically. In Los Angeles County (10,000,000) population, there were only a handful of Covid-related deaths in the most recent reported week, and daily new cases have dropped almost 90% since late January. Overall, statewide daily new cases have plunged 92% since late January.

Governor Newsom: please open the California economy NOW!

Chart #3

Chart #3 is one of my perennial favorites, since it shows the Fed has been responsible for almost every recession in the past 60+ years (the notable exception being the brief Covid crackdown recession that started a year ago). Recessions (gray bars) have occurred after every major spike in the real Fed funds rate (blue line) and every major flattening or inversion of the yield curve (red line). The purpose of Fed tightening has always been to increase real interest rates (and effective borrowing costs) in order to break the back of rising inflation. (Higher real interest rates work to increase the demand for money thus reducing the amount of excess money in the system at the same time the Fed is withdrawing reserves and shrinking the supply of money.) A significant tightening of monetary policy also causes the yield curve to flatten and to eventually invert (when long-term rates fall below the level of short-term rates). An inverted yield curve almost always means that monetary policy is so tight the economy begins to suffer and the market realizes that the Fed will soon have to reverse course.

As should also be apparent, we are nowhere near either of those conditions at present. Real interest rates are exceptionally low, and the Fed has promised to keep them there for a looonnnggg time. (I have serious doubts they will actually do that however). The yield curve has steepened a bit, which is a sign that the bond market realizes that the economy is improving and the Fed will eventually have to raise short-term rates at some time in the future. But it is not very steep from an historical perspective. 

Other indicators that have traditionally signaled that monetary policy is so tight that it is threatening economic growth prospects—such as 2-yr swap spreads and Credit Default Swap spreads—are firmly at the low end of their historical ranges. That means that liquidity is abundant and the outlook for corporate profits is positive. In short, there are no warning signs of economic trouble ahead to be found in the market. 

I would ordinarily be ecstatic about the prospects for the economy, were it not for a growing number of disturbing developments such as huge increases in government spending, promises of huge increases in a broad range of taxes, growing federal control over the economy, continued lockdowns and mask mandates, and expanded welfare measures (e.g., higher minimum wages and increased healthcare subsidies). Most troubling is the prospect of a significant increase in inflation, since that inevitably erodes standards of living, raises barriers to savings and investment, and works to transfer the burden of a mountain of government debt to the private sector in devious and pernicious ways.

All the things that worry me share a common denominator: they serve to reduce the incentives to work and invest. In short, they are anti-supply side. As a supply-sider, I firmly believe that the only way to truly stimulate an economy is to increase the incentives to work and invest by reducing tax burdens, keeping the value of the currency stable, and minimizing the amount of government intrusion in the economy.

This is a very wealthy country

Today the Fed released its estimates of household net worth as of the end of December 2020. Net worth has reached a new record high in nominal, real, and per capita terms. Covid has been a disaster, to be sure, but the US economy is healthy and poised to continue to prosper, albeit at a much slower rate than we have seen in the past. Here are some charts that tell the story, which is for the most part very impressive.

Chart #1

As Chart #1 shows, the private sector of the US economy currently has a net worth (total assets minus liabilities) of more than $130 trillion. That's up $12 trillion from a year ago, for a growth rate of 10%. Financial assets have done the best, but noteworthy is the relatively small increased in household liabilities since just before the Great Recession: liabilities have gone from $14.5 trillion at the end of 2007 to only $17.1 trillion as of a few months ago, for a growth rate of only 1.3% per year. Real estate holdings, meanwhile, have gone from $25.8 trillion (that was just after the peak of the housing boom) to $35.8 trillion at the end of 2020, for a growth rate of only 2.6% per year. 

Chart #2

Chart #2 adjusts the net worth figures for inflation, and uses a semi-log scale for the y-axis to show that over the long haul, real net worth in the US has increased by an annualized rate of about 3.6% per year. Recent experience is not at all out of line with what we've seen in the past.

Chart #3

Chart #3 further adjusts the net worth figures, subtracting inflation and dividing by the size of the US population. Here again we see a fairly steady rate of growth over the years, but it does look like the current number is on the strong side of what we might have expected. Regardless, the average person in the US enjoys a net worth of about $390,000. Yes, of course that number is inflated due to the estimated 2,100 billionaires we have amongst us, whose total net worth is estimated to be about $8 trillion. (I'm sure it's even more today given stock market gains year to date.) But if we subtract that from the $131 trillion of total net worth and divide by population, we still get a pretty healthy value for the average person: $333,000.

I don't know what the median value of per capita wealth is, but it's important to remember that our collective net worth is based on the wealth-generating value of all the assets we collectively own. Everyone benefits from all the roads, infrastructure, phones, computers, cars, machinery, etc., even if not everyone owns things. Office workers don't own their office building, but without it and without all the US infrastructure that has been built up over the years, they would most be earning far less. Our massive net worth as a country translates directly into the highest living standards we have ever enjoyed.

Chart #4

Sadly, total federal debt held by the public is now roughly equal to our annual GDP (roughly $22 trillion). This is the highest level of debt by far since just after WW II. But relative to our net worth as a country, it is only slightly higher than it has been for most of the past decade. This is not a picture of impending disaster, but I sure wish we weren't going to be borrowing another $4-5 trillion this year.

Chart #5

And despite its enormous size and ongoing (and staggering) growth, Chart #5 shows that the burden of all that debt (i.e., total interest payments on the debt relative to GDP, a proxy for our annual income) is about as low as it has been for many decades, thanks to today's extremely low interest rates. Our national debt is not about to kill us. But since the driver of all the new debt is mostly profligate spending (e.g., huge transfer payments, subsidies, and generally wasteful spending) which does little or nothing to make our economy bigger or healthier. We've been consuming a lot of our seed corn, instead of saving and investing for the future, and this can't go on forever without serious and unpleasant consequences. 

Running up debt the way we are will only serve to weaken our economy over the long run, making future gains in net worth far less than we have enjoyed to date. This will mean a much slower rise in living standards for our children and grandchildren than we have been enjoying.

Chart #6

Our federal government is spending money like a drunken sailor, but the private sector, fortunately, has been very prudent. Chart #6 shows private sector leverage: total household liabilities as a percent of total assets. Leverage today is as low as it has been since 1976, and it has declined by a huge 40% since the peak in early 2009. 

Chart #7

Chart #7 compares the performance of the US stock market to that of the Eurozone. The US is kicking a**. Note that both y-axes are semi-log and use the same ratio from top to bottom. The S&P 500 has gone up by more than double the increase in the Euro Stoxx index since early 2009. This is huge, and quite remarkable. 

More signs that inflation is set to increase

For many years I have been unconcerned about the Fed's conduct of monetary policy. To be fair, neither has the market (inflation expectations priced into Treasury notes have been subdued), and neither have legions of economists who have noted that the inflationary impetus of the Fed's expansive monetary policy has been kept in check by the decidedly and protracted sub-par rate of economic growth (~2% per year) over the past decade or so.

Nevertheless, my reasons for being unconcerned are distinctly different from the prevailing view. I think inflation has been held in check by the public's apparently voracious demand for money and money equivalents. The Fed has not so much flooded the market with liquidity as it has supplied money—sometimes reluctantly—in order to satisfy the public's desire for money. As Milton Friedman taught us, when the supply of money is matched by the demand for money, no inflation results.

In any event, the Fed has not "printed" money with abandon, since it has simply transmogrified notes and bonds into T-bill equivalents by buying them and paying for them with bank reserves, which are not money in the traditional sense, since they can only be held by banks. Banks have apparently been quite happy to hold on to the more than $3 trillion of bank reserves that the Fed has issued this past year, because those reserves are an attractive asset (default free) and they pay a floating rate of interest (the Fed funds rate). Simply put, the Fed has taken in notes and bonds (which are in abundant supply, thanks to trillion-dollar deficits) and exchanged them for T-bill equivalents, which have been in short supply. Nothing at all wrong with that.

Banks used their strong cash inflows during the onset of the Covid crisis—in the form of increased bank savings deposits and checking accounts—to purchase the notes and bonds which they then sold to the Fed.

More recently, I've become concerned that the return of confidence and a rebounding economy would result in a decline in the public's demand for all that money, and that the Fed would be slow to react with offsetting measures: a) higher short-term interest rates, which would work to boost the demand for money, and/or b) a reversal of its quantitative easing (which would withdraw unwanted bank reserves from the financial system). Per Friedman, that is the classic recipe for a rising price level (i.e., create a surplus of money relative to the demand for it). So far, the Fed seems determined to do just that—to ignore (and even welcome!) signs of declining money demand and rising inflation. Moreover, they fully intend to keep purchasing more notes and bonds in the months ahead. It's getting increasingly likely that the supply of bank reserves will exceed banks' desire to hold them as assets. Going forward, banks could well begin to expand their lending (abundant reserves make this possible), which is a sure-fire way to increase the amount of money in the economy. A future tsunami of money would almost certainly "float" higher prices for just about everything.

To once again be fair, the market is also beginning to get concerned about rising inflation: inflation expectations over the next 5 years have risen from 0.5% last summer to now over 2.5% per year (see Chart #1 below). What I'm saying is that there could be a lot more of this in the future.

Today Congress sent a $1.9 trillion spending bill to President Biden's desk, and he will almost certainly sign it in short order. In deja vu fashion, it passed very narrowly without a single Republican vote—just like Obamacare. In my view, it will do just about everything wrong. Far from "stimulating" the economy, it will instead greatly expand the welfare state and greatly increase the power of the federal government. Worse still, it will artificially inflate demand for just about everything but larger checking and savings deposits. Taking money from the economy (by selling notes and bonds) can't possibly stimulate the economy, just as taking a bucket of water from one end of a swimming pool and dumping it in the other end won't raise the water level. A lot of the money dished out by the bill is going to end up being used by people paying higher prices for all sorts of things. We see the beginnings of this already in, for example, the market for used cars (see Chart #4 below).

The economy doesn't need more demand, it needs more people working and more businesses reopening. Paying more to those who are still unemployed (plus exempting those higher unemployment benefits from taxation, as the bill does) won't encourage them to return to work. On the contrary, it will unnecessarily prolong the return to full employment. Many workers will surely discover that they can earn more (after-tax) than they could by going back to work. See my friend Steve Moore's estimates of just how pernicious this could be. And do subscribe to his daily newsletter, which has gobs of depressing facts and statistics.

The economy undoubtedly will get a boost in the months to come, but mainly because the Covid crisis is in rapid retreat. Daily new cases in the US are down almost 80% since the peak of mid-January. In California, they are down an astonishing 90% over the same period. We are rapidly approaching herd immunity, with estimates that upwards of 50-60% of the population has by now acquired immunity, either through infection, innate immunity (T-cells), or vaccination.

As is to be expected, by the time politicians rush in to supply aid to an ailing economy it is no longer needed. Moreover, it is counter-productive. Politicians almost always screw things up. That's why I'm a libertarian: we need less government, not more, to solve our problems.

Chart #1

Chart #1 shows the level of 5-yr nominal (red) and real (blue) Treasury yields, along with the difference between the two (green) which is what the bond market expects annual CPI inflation to average over the next 5 years. This latter has jumped from 0.5% last summer to now over 2.5%. Note that virtually all of the rise in inflation expectations is due to the rise in nominal yields. Real yields are very low, and they have barely budged; that's a sign that the rise in rates is not due to increased growth expectations—it's mostly due to increased inflation expectations.

Chart #2

Chart #2 shows how gasoline prices have surged in recent months. People are driving more, economic activity is on the rise, and oil prices have risen as demand challenges supply. 

Chart #3

But as Chart #3 suggests, while higher oil and gasoline prices will certainly contribute to rising inflation, there are other, more powerful forces also at work. Rising inflation expectations far exceed the contribution to inflation resulting from higher oil prices. 

Chart #4

As Chart #4 shows, used car prices have exploded since last summer. Extra cash seems to be burning holes in many consumers' pockets, and that could be fueling the rise in prices.

Chart #5

Chart #5 compares the yield on 10-yr Treasuries (red) with the ratio of copper to gold prices (blue). Both of these variables tend to rise and fall as economic growth prospects improve and deteriorate. This market-based indicator is telling us that there is a lot of construction activity (copper demand) going on around the world, and the bond market is sensing that the prospects for an increase in nominal activity have improved from last summer's abysmally low levels. 

Chart #6

Chart #6 is a long-time favorite of mine, if only because it shows how tightly correlated the prices of these two assets (gold and TIPS) have been for the past 15 years. (I use the inverse of the real yield on TIPS as a proxy for their price.) It also suggests that gold prices tend to move in advance of TIPS prices. Right now that is telling us that TIPS prices are likely to decline (as real yields rise) in the future, but not by a whole lot. I would fully expect a big rise in real yields to happen at some point in the foreseeable future, either as a result of a stronger economy and/or a Fed tightening (which in turn would likely be a response to an unpleasant and/or unwanted increase in inflation). It's also interesting that gold prices have declined so much in the past year at the same time inflation expectations have risen. Gold is an imperfect inflation hedge, to say the least. Gold these days is likely being challenged by stronger growth expectations and the prospect of a tighter Fed in the future.

As I've said in earlier posts, although there is no shortage of reasons to be concerned about the future—number one being a significant rise in inflation followed by a Fed tightening response—I don't think things will collapse for at least the next 3-6 months. Indeed, there is every reason the economic landscape should brighten in the months ahead as the Covid crisis fades into history. It's unfortunate that the government seems hell-bent on doing the opposite of what is needed, but despite all the damage that may be done by the stimulus bill, a rebounding US and global economy—and higher prices—should provide significant support to the equity market. 

And besides, what alternative is there, if cash yields zero? The expected return on cash is virtually guaranteed to be negative, as inflation rises and the purchasing power of cash declines. And don't forget that equities give you exposure to a rising price level, just as real estate does. As I've said repeatedly, what the Fed is telling you to do its "borrow and buy." The Fed wants you to shun cash, and the Fed almost always gets what it wants eventually.

The profoundly disturbing side of the Covid crisis

My long-term rational optimism was seriously challenged this morning after reading two essays. The issue that will likely haunt us and our economy for years to come is the inordinate expansion and intrusion of government into our daily lives and into the conduct of our private business affairs. Once politicians discover they have powers that were heretofore virtually unthinkable, they are very unlikely to relinquish those powers unless and until the population mounts a vociferous resistance—which so far is barely audible.

Scott Atlas: The Last Word

excerpt:

I have been shocked at the enormous power of the government, to unilaterally decree, to simply close businesses and schools by edict, restrict personal movement, mandate behavior, and eliminate our most basic freedoms, without any end and little accountability.

I remain surprised at the acceptance by the American people of draconian rules, restrictions, and unprecedented mandates, even those that are arbitrary, destructive, and wholly unscientific.

The United States is on the precipice of losing its cherished freedoms, with censorship and cancellation of all those who bring views forward that differ from the “accepted mainstream."

"Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one." - Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds

 

Masks Are Just Part of the Socialists' Uniform – J.B. Shurk

excerpt:

The Centers for Disease Control released another study showing no statistically significant decrease in "daily case" or "death growth" rates from COVID-19 in areas with mask mandates. This comes after a similar CDC study in October indicated that mask mandates do not appear to have slowed or stopped the spread of the coronavirus at all. Still, the CDC continues to recommend that all Americans wear masks, except in certain private settings when individuals are fully vaccinated, unless the goalpost-shifting Dr. Fauci gets his way.

Mask mandates are also an illustration of the sharp philosophical divide straining Americans into two camps guided by conflicting worldviews. In the one are true democrats who believe that all legitimate government power is derived from individual consent, and in the other are true socialists who sanctify the exercise of government power in pursuit of collectivist goals at the expense of individual liberty.

Alexis de Tocqueville contrasted these worldviews aptly: "Democracy extends the sphere of individual freedom; socialism restricts it. Democracy attaches all possible value to each man; socialism makes each man a mere agent, a mere number. Democracy and socialism have nothing in common but one word: equality. But notice the difference: while democracy seeks equality in liberty, socialism seeks equality in restraint and servitude."

... mask mandates have become nothing more than dress code loyalty oaths to the same state and local governments that have claimed for themselves the extraconstitutional powers to restrict free speech, religious liberty, personal commerce, and voluntary movement beyond the home in the name of a virus. They represent Americans' symbolic acquiescence to government's mass lockdowns and economic shutdowns and their tacit acceptance that government's unconstitutional power grabs are somehow legitimate.

Finally: “Masks have been transformed from tools that are moderately useful in the right circumstances to magical totems. The sort of thing that a . . . neanderthal might employ against disease.” - Glenn Reynolds

It's time to end the Covid mandates and lockdowns everywhere

Just look at the charts and facts on this page (screen shot below) and you will see that that lockdowns and mask mandates don't change the course of the Covid pandemic and in fact just make things worse. 

Reminder of what I said last April: "The shutdown of the US economy will prove to be the most expensive self-inflicted injury in the history of mankind.™" What a disaster it has been, and all for nothing. Indeed, we have more problems now, thanks to the lockdowns, than we would have had without them. 

The good news, however, is very encouraging, as the last chart on this page shows. The US population is rapidly nearing the point at which it achieves herd immunity. It's no wonder, then, that the number of daily new cases (7-day moving average) in the US is down 75% since the peak of January 11, '21. In California, daily new cases are now down 90% from their peak.