Money and inflation update

With today's release of the August CPI, it looks on the surface as if inflation is moderating, much as the Fed has been hoping. Looking deeper, though, I think it still pays to be skeptical—especially since the belief that this inflation flareup is merely transitory has been fully embraced by the bond market. Witness breakeven inflation rates of 2.3% on 5-yr TIPS. 

Chart #1

At the risk of making a fool of myself, I am going to assert that Chart #1 is what really makes this time different. Never before in the monetary history of the US has there been such a huge increase in the M2 money supply. The increased M2 growth we saw in the wake of the Fed's QE1 and QE2 casings were barely perceptible, as the chart demonstrates.

Now, large and rapid growth in the money supply isn't necessarily inflationary, providing it occurs at a time when the demand for money is surging. I think that was the case a year ago, given the Covid shutdowns that virtually paralyzed economic activity and the massive increase in spending as governments worldwide attempted to keep tens of millions of displaced workers afloat. But this year, things have improved dramatically. GDP has recovered all its lost ground and then some. Corporate profits are at a new high. Nobody today wants to have as much money on his balance sheet as he had last year at this time. 

Chart #2

Chart #2 shows how the mini-surge in inflation in the sunup to the Great Recession was later reversed. That's a picture of transitory inflation, I suppose, but don't forget Chart #1. The Fed never allowed the money supply to explode back then, and they kept interest rates much higher then they are now. The Fed was tight, and that's one thing that aggravated the crisis of 2008. So it's not surprising that inflation proved transitory.

But today is different. As Chart #2 shows, the Ex-energy version of the CPI has moved well above its long-term 2% trend. For the current inflation episode to prove transitory, the blue line is going to have rise at a much slower pace in the months ahead. And the M2 money supply is going to have to do the same. So far we see no evidence of either.

Chart #3

Chart #3 shows the 6-mo. annualized growth of the ex-energy and headline versions of the CPI. This measure is much more representative, in my view, of what is happening to inflation right now. A year over year version (which shows a distinctive slowdown) is muddied by the economic chaos that occurred in the summer of last year. Better to use data from the current year. By this measure, there has been no meaningful slowdown in inflation.

Chart #4

Today also saw the release of the Small Business Optimism survey. As Chart #4 shows, small businesses reported an explosion of price increases of a magnitude not seen since the inflationary 1970s. Prices for a whole lot of things are going up. This is big. 

Chart #5

As Chart #5 shows, housing prices nationwide are up by almost 20% in the past year (blue line). The red line represents the growth rate of the CPI component called "Owner's Equivalent Rent." I have shifted the red line to the left by 18 months, in an attempt to show that big increases in housing prices are followed, about 18 months later, by big increases in the OER component of the CPI (which represents almost 40% of the CPI, by the way). According to this chart, we have only seen the first glimmerings of a pickup in OER (and the CPI as well, by inference). Robust growth in housing prices this past year already strongly suggests we'll see a significant pickup in the CPI over the next 6-9 months. 

Chart #6

Meanwhile, the real yield on Treasury notes and bonds has become deeply negative, thanks to extremely low yields and a surge in inflation, as we see in Chart #6.. This represents a stiff penalty on anyone seeking a safe haven. This penalty is discouraging people from owning safe assets. It encourages people to spend some of the extra cash they have accumulated in the Covid era. And that is what is fueling price rises everywhere. This won't stop until real yields become much more attractive. And for that to happen we need to see the Fed raise rates and we need to see inflation come down. Unfortunately, neither of those conditions are likely to occur in the next year.

Chart #7

At the suggestion of a reader, I've updated Chart #7, a chart I have been featuring for many years now. My reading of this chart is that the market is still a bit nervous about the economy going forward, because the Vix at today's level of 18-20 is still somewhat elevated. But fears have been slowly subsiding, and so money has been finding its way into equity prices, among other things. Which is logical, since equities represent ownership of tangible and productive assets, and thus are a good hedge against inflation. And anyway, corporate profits are on the moon, as I pointed out last month. Housing and the stock market are the big beneficiaries of today's money abundance.