Monday, July 19, 2021

A closer look at the Covid-related surge in M2

In my previous post I referenced the huge increase in the M2 money supply over the past 16 months, noting that much of the increase that occurred in the wake of the Covid panic (I estimated as much as $3 trillion) was money that likely was no longer wanted by its holders, given the improvement in confidence, the rapid decline in Covid cases, and the subsequent improvement in the economy. I further argued that this unwanted money was the likely fuel for the rising prices of many goods and services. This post provides some data to back up my point.

Chart #1

Chart #1 shows the level of Bank Reserves provided by the Fed to the banking system. Reserves are the only type of money the Fed can directly "create," and reserves can only be created for the purpose of buying high quality assets, which typically means Treasury securities—but more recently has come to include mortgage-backed securities and some corporate bonds. The Fed purchases these assets from the banking system, and the reserves it uses to pay for them are credited to the banks' accounts at the Fed. Reserves cannot be used to buy anything else, and they are only and always held on the Fed's books (i.e., they are liabilities on the Fed's balance sheet). Banks have traditionally held reserves as collateral for new lending, since by law banks must hold reserves equal to about 10% of their deposits. Today, however, banks hold reserves far in excess of what is required, and they do so because in 2008 the Fed started paying interest on reserves—and that, in turn, made bank reserves functionally equivalent to T-bills: high quality, liquid, default-free and carrying a floating interest rate. Prior to 2008, reserves were "dead" assets since they paid no interest yet banks were required to hold them—so banks tried to hold as few reserves as possible. 

The current huge amount of bank reserves means that banks have effectively lent boatloads of money (about $5 trillion)  to the Fed, and most of that money has come from huge deposit inflows to checking and savings accounts. Banks also lend money to the private sector, of course, but lending to the Fed carries no risk while paying a very modest rate of interest—currently 0.15%. If banks decide that the 0.15% interest they receive from the Fed has become unattractive relative to what they could earn by lending to the public sector (on a risk-adjusted basis), today's huge level of reserves means that banks have a virtually unlimited capacity to expand their lending—which is what expands the money supply. Only banks can create spendable money under our fractional reserve banking system. When a bank decides to lend you money, they simply credit your account with newly-minted money. You then use that money to buy other things, and that money enters into circulation as someone else receives it in their bank account.

As the chart also shows, the Fed has expanded its issuance of reserves by about $2.24 trillion since February of last year. This is almost as much as the $2.8 trillion of reserves created by three previous waves of Quantitative Easing from late 2008 through mid-2014. Those three waves of Quantitative Easings didn't lead to an unusual pickup in inflation, but QE4 did. Why is that?

Chart #2

Chart #2 provides the answer. It shows the level of the M2 money supply (which consists mainly of currency and bank checking and savings deposits, plus ) plotted on a semi-log y-axis to make it easy to see constant growth rates (a straight line means a constant rate of growth). For the 25 years prior to Covid, the M2 money supply expanded by a little over 6% per year, and consumer price inflation averaged about 2.2% per year. (See Chart #4 in my previous post.) Then in 2020 everything changed: banks apparently used their abundant supply of QE4-provided reserves to increase their lending, which in turn has resulted in a significant increase in currency and bank deposits. The "gap" I highlight is the result of a surge in money creation well above and beyond previous growth rates. M2 grew by about $5 trillion (33%) from the end of February 2020 through the end of June this year, and the lion's share of that increase came from an increase in retail bank savings and checking accounts, plus about $300 billion the form of currency in circulation.

At the beginning that was fine, since everyone scrambled to stockpile money as the economy shut down. But now people's desire to hold money is very likely declining as life gets back to normal. I'm guessing there's as much as $3 trillion of money in the banking system that is now "unwanted."

The problem, of course, is that money can't just disappear if people don't want it. If I want to reduce the balance in my bank savings account, I need to spend it on something else. The person who receives my money must then do something with the money. 

There are three ways the banking system can get rid of unwanted money: 1) Borrowers can pay off their bank loans (since bank lending is the fount of all money supply growth), 2) the Fed can drain reserves from the banking system by selling some of the bonds it bought (thus reducing excess bank reserves and banks' ability to increase lending), and 3) inflation can increase the price level and the level of incomes by enough to return people's desired cash balances (e.g., the ratio M2 to annual incomes) to reasonable levels. I think #3 is going to be the dominant factor.

What we have seen in the past 16 months is unique in the monetary history of the US: a massive and sudden expansion of M2 that far exceeds anything we've seen before. To me, it's no surprise that inflation is surging.

Tuesday, July 13, 2021

Big changes in inflation and government finances

Today's data releases brought some real surprises for the market, both good and bad: consumer price inflation in June came in much higher than expected (+0.9% vs. +0.5%) and federal revenues surged. 

I've been predicting higher than expected inflation for some time now, so today's numbers were not a surprise to me. The market barely budged, since there appears to be an overwhelming consensus—reinforced by the Fed numerous times—that higher inflation is merely transitory and in fact, welcome, given the Fed's desire to see inflation average well over 2% a year for a few years. I don't see the rationale for these views, however, and I expect to see big changes in market expectations in the next year.

My thesis has been, and continues to be, that the huge increase in M2 that we saw over the past 16 months was initially not worrisome, since the world's demand for M2 money (mostly cash and bank savings deposits) was driven through the roof by the panic and uncertainties generated by the Covid-19 crisis. The peak of the Covid crisis was arguably last November, when successful vaccine trials were announced. Since then new Covid cases have plunged, confidence has soared, and the economy has rebounded sharply, which in turn means that the demand for all that extra money has all but vanished. Unfortunately, the Fed has taken no steps to offset this. This has left the economy with upwards of $3 trillion in unwanted cash (as I have explained in previous posts). Now that prices are surging, the interest rate that the holders of all that cash receive is hugely negative. Who wants to hold $3 trillion in extra cash that is losing purchasing power at the rate of 10% a year? No wonder prices are rising, and they will continue to rise as the public attempts to reduce their money balances in favor of things (e.g., commodities, property, equities) that promise much better returns.

It's simple: The economy is loaded with unwanted cash, and the real (inflation-adjusted) return on that cash (and the real return on almost all fixed-income instruments) is hugely negative. This is an untenable and unsustainable situation which will cause inflation to rise even more. It will only end when the Fed realizes it has made a mistake and starts jacking short-term rates higher, and/or starts draining cash by selling trillions worth of bonds. 

On the bright side, the June Treasury report saw a huge surge in revenues that was largely unexpected. The catastrophic budget deterioration that we saw for the past 16 months now looks to have turned the corner. There is hope for the future! Unless, of course, the Biden administration succeeds in passing another multi-trillion spending lalapaloosa. Fortunately, the likelihood of that is diminishing by the day—in my opinion.

Here's a huge and very under-appreciated fact: an unexpected and significant rise in inflation is a boon to federal finances. Why? Because it creates an "inflation tax." Anyone who owns a Treasury security these days is effectively receiving a negative rate of interest that could be as high as 10% per year. The average yield on Treasuries today is somewhere in the neighborhood of 1 - 1½%. So at the current rate of CPI inflation (almost 10% annualized), Treasury debt is "costing" the government -8 ½ to -9% per year. That is, the real value of the debt is declining by that amount. With debt owed to the public now just over $22 trillion, that's like a gift of roughly $2 trillion per year to the federal government! In the 12 months ending June '21, the federal deficit was $2.6 trillion. This year's inflation tax will pay for about 75% of that. In other words, inflation this year will take about $2 trillion out of the pockets of those owning Treasuries and give it to the federal government. Why bother with raising taxes? (Did I mention that this is the way the Argentine government finances itself?)

So it is with mixed emotions that I detail some of this story with charts:

Chart #1

Chart #1 shows how consumer confidence has surged since late last year. The wild gyrations of confidence in the past year explains why the demand for money rose in the first half of last year and is now falling. The future looks much less scary now, so who needs a ton of money sitting in their bank account earning nothing? 

Chart #2

Chart #2 looks at the ratio of gold to oil prices. This ratio has been remarkably stable—on average—over time, with an ounce of gold buying about 20 barrels of oil. Another thing this chart shows is that the prices of these two very different commodities have tended to rise by about the same amount over time.

Chart #3

As Chart #3 shows, crude oil today costs about $75 a barrel, which is not a lot more than its long-term inflation-adjusted value of $59. Oil arguably is thus a contributing factor to today's rising prices, but not significantly so.

Chart #4

Chart #4 shows the level of the ex-energy version of the Consumer Price Index, plotted on a semi-log scale in order to show that the rate of increase in the prices of goods and services in this basket has been remarkably stable at about 2% per year—until this year, that is. The index so far this year has surged at a 7.4% annualized rate. This cannot be explained away by referring to the fact that prices were soft in the second quarter of last year. We are looking here at an inflation breakout.

Chart #5

Chart #5 shows the 6-mo. annualized change of both the total CPI and the ex-energy version. We haven't seen inflation like this since the period just before the Great Recession. Recall that the Fed tightening needed to rein in that inflation episode was, I would argue, the proximate cause of that recession.

Chart #6

Chart #6 shows the 3-mo. annualized rate of inflation according to the Core CPI (ex-food and energy). This measure of inflation now stands at 10.6%, a level not seen since the early 1980s. 

Chart #7

No matter which sub-index of inflation you look at, prices are surging. Chart #7 shows that 47% of small business owners report seeing a meaningful rise in prices. That's a level we haven't seen since March of 1981, when the U.S. economy was still suffering from double-digit inflation. 

Chart #8

Chart #8 shows the level of real and nominal yields on 5-yr Treasury securities, and the difference between the two (green line) which is the market's expected average rate of inflation over the next 5 years. It's amazing to me that inflation expectations still appear to be relatively tame, despite today's blowout inflation report. 

Chart #9

Chart #9 compares the real yield on 5-yr TIPS to the current real yield on the overnight federal funds rate, which is now much more negative than it has ever been. The real yield on TIPS is equivalent to what the market expects the real fed funds rate to average over the next 5 years. It's nothing less than astonishing that the market calmly expects the real fed funds rate to average -1.8% per year over the next 5 years! Does it make sense for anyone to hold overnight and short-term Treasuries if they are going to generate a significant loss of purchasing power for the next 5 years? This is unsustainable and illogical in my book.  

Chart #10

Chart #10 should warm the cockles of many politicians' hearts. All of these lines represent the rolling 12-month total of Treasury revenues from different sources. Note the spectacular increase in individual income tax receipts and corporate income tax receipts in recent months!

Chart #11

Chart #11 shows the trend of federal spending and revenues. The gap between the two (the deficit) has narrowed in the past few months.

Chart #12

Chart #12 puts federal finances into a proper perspective by measuring each as a % of GDP. Revenues are now coming in at a higher level than the post-war average! Spending is still absurdly high, but declining.

Chart #13

Finally, Chart #13 shows the federal budget deficit as a % of GDP. The deficit soared to an unheard-of level of more than 18% of GDP thanks to trillions of dollars of checks sent out all over the place. The deficit currently is back down to 12% of GDP, which is still absurdly high, but at the rate things are going we should see a further dramatic improvement in the budget outlook in the months to come. 

And don't forget the inflation tax, which doesn't show on any of these charts. It could contribute about $2 trillion—effectively—towards paying down the debt this year alone. 

It's going to be a wild ride for the foreseeable future, but it's difficult to quantify and it's difficult to recommend a course of action. Despite the potentially huge amount of uncertainty we are likely to be facing in the coming months or years, one thing does not recommend itself, and that is holding cash. Cash has traditionally been the best port in a storm, but that is most definitely not the case today, and neither is holding any short- or medium-term Treasury security.

Wednesday, June 30, 2021

Argentine inflation lessons for the U.S.

This is a rather long post, but it should prove of interest to all those worrying about the possibility of a non-transient and significant increase in U.S. inflation. I've drawn much of it from my previous posts on the subject of Argentina and inflation.

I first visited Argentina in 1970, when I spent my summer there visiting my soon-to-be wife. The country has intrigued, fascinated, and frustrated me ever since. In 1975 we decided to move there and I've been an avid student of monetary policy and inflation ever since. In 1976 we witnessed the military overthrow of the disastrous government of Isabel PerĂ³n. After a few years of "relative" stability under a military dictatorship, things began to deteriorate about a year or two after we returned to the States in 1979. Our timing couldn't have been better. By the late 1980s, Argentina was spinning out of control, as its annual inflation rate peaked at over 20,000%. During a visit to the country around that time I was fascinated to watch hyperinflation unfold: prices almost tripled within the span of three weeks. Miraculously—or so it seemed—inflation subsequently fell to zero by the mid-1990s, thanks to the government's decision in 1991 to peg the peso at 1-1 to the dollar.

During the four years we lived in Argentina, inflation averaged about 7% a month. That adds up to an annual inflation rate of 125%, and that's enough to seriously impact your everyday life. My first memory of when the reality of inflation hit me was the day I collected my first paycheck. I began thinking "what should I do with this money?" Keeping the money in my pocket or under the mattress made no sense, since the money was losing value constantly—because prices were rising constantly. The decision was easy: we had to spend the money, and spend it fast. So my wife and I set off for the nearest warehouse store to buy "stuff" that we could store in the closet. Canned foods and powdered milk for our 1-year old infant ranked high on our list. We scoured the store and found a bunch of storable stuff, but we couldn't find any milk. I thought that was curious, because it was very popular (Leche Nido, by Nestle). But then I opened a door to an adjacent storage room and saw boxes of powdered milk stacked to the rafters. So I asked the girl at the cash register if someone could fetch us a couple of boxes. "I'm sorry, sir," she replied. "The milk is not for sale."

That's when it dawned on me that everyone was thinking like I was: nobody wanted money, everyone wanted stuff instead. For the next several years I would juggle money balances between pesos and dollars and "stuff." With lots of inflation, money becomes like a hot potato. When I saw something for sale that I needed and the price looked reasonable, I would buy it immediately, because I learned that if you waited to look for it in another store, the price was likely to go up. During one episode of very high inflation, grocery stores would post prices on chalkboards, and change them throughout the day. It was a daily struggle to survive, because salaries and wages always went up after the prices for "stuff" went up (incomes lagged prices, and over time that impoverishes wage earners). 

In 1979 we sold our house, in preparation for returning to the U.S. There was no such thing as a mortgage at that time, and hardly anyone had a checking account. If you wanted to buy a house, the best terms you could find were "0-30-90," which meant that you had to pay one-third of the purchase price at the time of signing the purchase contract, followed by the second third a month later and the final third in three months. The man who bought our house (for the equivalent of about $30,000) graciously agreed to pay me the full amount in cash at the signing of escrow. Before going to the escrow office to finalize the deal, we went to his office. There he took out several grocery bags full of peso bills and started counting the bills; after counting each stack he passed it over to me, and I counted it, then he placed the stack back in one of the bags. I wish I could remember what the price of the house was in pesos, but all I remember is that the bills were of large denomination and they filled three grocery bags—it took us a half hour to count it all. After we had both counted the money and signed the escrow papers, he accompanied me to the bank to help me carry all the money and to serve as an informal body guard—can you imagine carrying cash equal to the price of a house in grocery bags while walking 6 blocks to the bank? I handed over the bags of money to the cashier and explained that I wanted to convert the pesos to dollars and wire the total amount to my account in the U.S. It took the cashier 20 minutes to count and verify the bills. I was fortunate that at the time it was legal to convert pesos to dollars and to wire dollars to an overseas bank account—it hasn't always been like that, and it isn't today.

When we visited Argentina in 1986, I remember my 6-year-old son was fascinated by all the banknotes that people carried around in order to conduct their daily transactions. They had denominations ranging from 3 to 8 digits. Prices were routinely quoted in "palos" with a palo being slang for a million, much as we would say "5 bucks." A friend gave my son a grocery bag full of old peso notes that he had collected, and he went almost crazy with delight. "Wow, Dad, how much can I buy with all this money?" he asked me. "Well, Ryan, with all that money you might be able to buy a pack of chewing gum," I replied, even though the nominal value of the notes must have been in the tens of millions. I then tried to explain to him how inflation worked, but I quickly realized he just couldn't understand it.

Years later I would study the situation in Argentina during the time we lived here and understand what was happening. In a nutshell, since the government was unable to finance its deficit by selling bonds, it simply ordered the central bank to print up new currency in order to pay its bills. New bills flooded the country like Monopoly money. Money became like a hot potato that nobody wanted to hold. Better to change my peso salary to dollars at the beginning of the month, and then convert back to pesos when I needed to buy something. Better to save money by buying stuff than to save money in the bank. Since very few people back then had bank accounts, newly-minted bills just kept accumulating in the economy and losing their value. A $1 million peso note issued in 1978 was initially worth several thousand dollars, but by the mid-1980s that same note was worth only 20 cents and was withdrawn from circulation.

Bottom line, the supply of pesos was growing rapidly at the same time that the demand for pesos was falling. This resulted in a huge increase in money velocity (which is equivalent to saying there was a huge decline in the demand for money), and the ratio of money to nominal GDP fell sharply for years and years. A 50% increase in the money supply could support a 70 or 80% rise in prices and nominal GDP. The government would periodically try to slow the rate of inflation by limiting money growth to a rate lower than the prevailing rate of inflation, but it never worked because the velocity of money just kept increasing. More and more people held their money balances in dollars instead of in pesos, and spent their pesos as fast as they could. The government was essentially financing its deficit via an inflation tax; as long as you were holding pesos in your hands, they were losing value and you were effectively paying money to the government. So everyone naturally tried to avoid holding pesos. It was a vicious circle, as rising inflation destroyed confidence and the demand for money, and that in turn fueled higher inflation.

The key feature of the U.S. monetary system—as distinct from Argentina's—is that the Fed cannot create money directly—only banks can do that. The Fed can, however, make it easier for banks to create money by increasing the supply of bank reserves. Banks need reserves in order to collateralize their deposits. The Fed creates reserves by buying securities (e.g., Treasury bills, notes and bonds, and more recently, mortgage-backed securities and some corporate bonds). In effect, the Fed buys securities and pays for them with bank reserves. But crucially, reserves are not money that can be spent anywhere.

In times of great uncertainty and surging money demand, like today, the Fed fills the market's need for short-term safe securities by buying riskier securities from the banking system and paying for them with risk-free reserves which pay a floating rate of interest; reserves thus have become T-bill equivalents. If banks don't find the reserves attractive they can use them to support increased lending, which indeed does result in a monetary expansion. But if that expansion exceeds the market's demand for money, then higher inflation will be the result. Throughout most of last year, the fact that inflation did not rise strongly suggests that the Fed's actions were not inflationary. Bank reserves—which swelled by about $4 trillion last year—served to satisfy the banking system's demand for risk-free, short-term assets, and the public's demand for a massive increase in bank savings deposits and checking accounts. Demand for money and money equivalents was turbo-charged last year by all the uncertainties and disruptions caused by the Covid-19 panic.

But now things are changing. Uncertainty is declining, and confidence is increasing. People don't want or need to hold so much money in the form of bank savings deposits. Prices for many things are rising, and measured inflation has accelerated significantly. The Fed argues that the rise in inflation is only transient, the result of lockdown-induced supply shortages coupled with exuberant demand from newly "liberated" consumers who no longer worry about Covid. The Fed also argues that "easy money" is necessary to help the economy back on its feet. I disagree. 

I think the Fed is making a big mistake by pegging short-term interest rates at a level that is far below the current rate of inflation. Holding cash or cash equivalents (e.g., bank savings deposits, checking accounts, T-bills, money market funds) pays virtually zero interest, just as holding actual cash does. But holding cash in your pocket or at the bank means you are losing money—you are effectively paying an inflation tax which amounts to as much as 8% per year (the CPI rose at an 8.45% annualized rate in the three months ending in May). 

Let that sink in. Your money balances are costing you 8% per year. Cash is not a safe asset these days. It's a very expensive asset, in fact. Better to get rid of cash by spending it on almost anything else, right? Buy land, buy powdered milk, buy stocks, buy commodities, fix up your home, buy a car, invest in new plant and equipment ... the list goes on, and not surprisingly, the prices of all those things are rising. It's Argentina deja vu all over again. Oh, and in addition to shedding unwanted cash, you might also consider borrowing money in order to buy things, since the cost of borrowing is less than the rate of increase in the prices of those things.

Current Fed policy amounts to a concerted effort to undermine the demand for money, at a time when the supply of money continues to surge. The M2 money supply has risen at a 15.4% annualized rate in the six months ending in May, and it's up at a 15.1% annualized rate in the three months ending in May. That's a classic prescription for rising inflation. For the two-decade period leading up to the Covid period, M2 growth averaged a little over 6% per year—and for that same period inflation was relatively low and stable.

It gets worse. The Fed is not just targeting a near-zero rate for short-term securities that is far below the current level of inflation, it is all but ensuring that the rate on short-term securities will continue to be far below the rate of inflation for at least the next two years—and possibly for as far as the eye can see. The market is in full agreement: the implied yield on 3-mo. LIBOR two years from now is 0.8%, which implies about 2 Fed tightenings in the interim. In fact, the entire Treasury yield curve, from 1 day out to 30 years, falls well below the current rate of inflation. The TIPS market provides further proof that interest rates are expected to be below the level of inflation for as far as the eye can see: 5-yr real TIPS yields are -1.6%, 10-yr real yields are -0.9%, and 30-yr real yields are -0.2%.

Who wants to hold Treasuries that will produce negative real returns for a lifetime? Who wants to hold cash that will lose up to 8% of its value in the next year? The longer real yields remain negative, the more the incentive to reduce one's holdings of cash and other "risk-free" securities, and the more the incentive to increase one's holdings of "stuff" that will on average appreciate by the rate of inflation. 

Economics is all about scarcity and incentives. Today the incentives are powerfully lined up to fuel a cycle of rising inflation. People respond to incentives, and they are voting with their feet. That's why the prices of things are rising, and that's why rising inflation is very unlikely to be a transient problem. Unless, of course, the Fed reverses course and begins jacking up short-term interest rates in a BIG way. Which in today's political environment seems unlikely.