Tuesday, September 14, 2021

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. 

Thursday, September 2, 2021

What's wrong with gold?

For months now, I've been asked by friends, colleagues and readers of this blog to explain why gold hasn't moved higher on the news that inflation is rising and the Fed is sitting on its hands, doing nothing to inspire confidence in inflation returning to their 2% target.

My answer is simple: gold has already risen significantly. 

This chart shows the inflation-adjusted price of gold in today's dollars. (I've used the CPI to do the calculation.) 

In the early 1970s, just before Nixon took the dollar off the gold standard, gold was extremely cheap, which is why many of the world's central banks were demanding that the Fed redeem dollars in exchange for gold. The federal government had been ramping up social spending and deficits and monetary policy had been too accommodative—they should have been tightening in the face of declining gold reserves. Faced with a huge drain on the Fed's gold reserves, Nixon chose to devalue the dollar rather than tightening monetary policy, since he (rightly) feared it would lead to a recession. 

Gold rose significantly over the course of the next 10 years, as did inflation, oil and most commodity prices. Inflation rose from a low of 2.7% in mid 1973 to a peak of almost 15% in early 1980. Gold peaked in September 1980. Gold then fell as inflation fell, reaching a low of 1.4 % in early 1998; gold hit bottom in 1999. Gold then rose to a peak in 2011, fell to a low in 2005, only to rise again until it peaked in 2020. 

One could argue that the rise in gold which began in 2000 was driven by the expectation that the Fed was prone to be too easy (after having been demonstrably "tight" from the early 1980s) and that inflation was a potential risk. Now we are seeing the Fed validate the fears built into gold prices. It's a case of "buy the rumor, sell the fact." Gold correctly anticipated today's inflation and today's Fed error, so now gold is looking into the future to see whether things will eventually get better or worse. 

In any event, gold today is only modestly below its all-time high in real terms. It's not cheap by any stretch. 

Tuesday, August 31, 2021

Home prices and the M2 surge

The latest Case-Shiller statistics for June (which is actually the average of April, May, and June prices) show that national home prices rose almost 20% from the prior year. This is by far the most dramatic increase in home prices ever recorded. Could it be a coincidence that the M2 money supply rose by 28% over this same period, also an all-time record? If we want to understand the burst of inflation that has occurred over the past year or so, we need look no further than the money supply. For prices to rise significantly across a range of assets and markets, there must be a corresponding and significant rise in the money supply.

With the Fed assuring us that there will be no reduction in its balance sheet and no meaningful increase in short-term interest rates through the end of next year, the US economy is going to be awash in extra money for a long time. The recent burst in inflation is therefore highly unlikely to prove temporary or transient.

This is huge and very unwelcome news.

Chart #1

Chart #1 shows the nominal and real index of national home prices, as calculated by the S&P CoreLogic Case-Shiller methodology, which is widely considered to be the gold standard for home price trends. Prices are now at all-time highs, both nominally and in inflation-adjusted terms. Prices are on track for blowing away the sky-high prices we last saw in 2005-2006, which in turn were temporarily goosed by crazed lending practices.

Chart #2

Chart #2 shows the year over year change in this index, about 18%. It's a safe bet that we'll see prices continue to rise for at least the next several months. 30-yr fixed rate mortgages are going for about 3% these days, which is only modestly higher than the all-time low of 2.85% which was set in February of this year. Those same rates averaged about 6% in 2006, by the way. 

Chart #3

Chart #3 documents the virtual explosion in the M2 money supply that began in March of last year. The M2 money supply is now (as of the end of July) about $3.7 trillion above its long-term trend line. That extra $3.7 trillion can be found almost entirely in retail bank checking and deposit accounts, all of which are readily convertible into spendable cash. We have never before seen anything like this in the monetary history of the US. We have seen things like this in Argentina, however, where soaring inflation has always been preceded and accompanied by huge growth in the money supply.

Milton Friedman must be rolling over in his grave these days.