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. 

Thursday, June 10, 2021

The US economy as seen from 30,000 feet

As the Covid-19 panic fades into the sunset, it's time to climb to 30,000 feet and review some of the economy's macro vital signs.

Despite the destructive impact of economic and social shutdowns which resulted in millions of lost jobs and businesses and untold damage to the physical and mental health of even more millions, and despite the government's efforts to ameliorate the damage by borrowing trillions in order to shovel money from the pockets of some into the pockets of many, the economy has emerged in amazingly good shape. In fact, the private sector is wealthier and more prosperous than ever before—although the benefits have undoubtedly been distributed unequally and often rather crudely. The public sector, on the other hand, has rung up a tab that will take generations to cover.

Lurking in the background of this surprisingly good news, however, is inflation, which is very much alive and well and prospering.

Chart #1

The Federal Reserve today released its estimates of household balance sheets, which are summarized in Chart #1. (Nonprofit organizations are included in these numbers.) Household wealth has blossomed, thanks to strong financial markets, lots of saving, real estate appreciation, and only a modest accumulation of debt.  

Chart #2

Chart #2 converts the net worth numbers in the first chart to real (inflation-adjusted) figures. Note that the y-axis is logarithmic, which renders steady growth rates into a straight line. Note further that the real net worth of the US private sector has risen slightly more than an annualized 3.6% per year over the past 70 years. It's worthwhile comparing this chart to Chart #16 in my previous post. Both paint a similar picture: net worth and equity prices have appreciated on average by a fairly steady rate over the long haul, and the trend lines I have added to each chart do a fairly good job of dividing above- and below-trend years into equal amounts. Both suggest that valuations and net worth today are somewhat above long-term trends, but not by an egregious amount. In short, the current period does not stand out in any extraordinary way from our long-standing experience.

Chart #3

Chart #3 uses the data from Chart #2 and divides it by the population of the US to get real per capita net worth (currently, the average person's share of total wealth is about $410,000). Here again we see a fairly steady rate of growth over time, but a bit more above trend in the past year. The obvious conclusion to be drawn from all of these charts is that further wealth and equity price gains are likely to be a lot less exciting in coming years than they have been in previous years. 

Chart #4

Chart #4 shows the ratio of total household debt to total household assets, which can be likened to the average degree of leverage employed by the private sector. Here we see a rather dramatic and ongoing decline in financial leverage that began back in 2008, in the depths of the Great Recession. That recession, as you might recall, owed quite a bit to the private sector's use of excessive leverage to buy homes in previous years. We've now rolled back the clock on leverage to the levels of the early 1970s. Which, curiously, was just before the great wave of inflation that lifted housing prices. (I daresay that the recent boom in inflation and housing prices are likely two sides of the same coin.)

Chart #5

In this umpteenth appearance of Chart #5, we see that the gains in equity prices in the past year have been accompanied by a decline in the Vix "fear" index. The Vix is still a bit above the levels that seem to prevail in "normal" times, so there may be room for further gains provided we avoid unpleasant surprises.

Chart #6

Chart #6 tracks the rolling 12-month total of federal spending and tax revenues. Covid-19 provided cover for the most dramatic increase in federal spending since WW II. Things are beginning to return to normal, it would seem, thanks to May's avalanche of tax receipts (thanks in turn to the capital gains generated by a strong stock market in late 2020) and a lessening in the pace of growth of spending. Still, the federal budget is for all intents and purposes very nearly out of control. Spending MUST be reined in or there will be hell to pay at some point. The problem is not so much the amount of debt, but rather the fact that enormous levels of spending are hugely wasteful and make for fertile terrain for graft and corruption. No country has ever borrowed and spent its way to prosperity. That we are not in ruins today is testimony to the hard work and prudence of our private sector, as the charts above document. 

The most important reason to cut spending is to improve the health of the economy, since government can never spend taxpayers' money as prudently, wisely, and efficiently as taxpayers can.

Chart #7

Chart #7 shows total federal revenues on a rolling 12-month basis (blue line) and its major components. The recent surge in revenues owes a lot to a surge in individual income tax receipts, which in turn have been boosted by capital gains revenue thanks to the strong stock market. Corporate income taxes have also increased thanks to strong profits growth in the latter half of the year.

Chart #8

Chart #8 makes a repeat appearance using the latest data. It's hard to believe, but true: the burden of the federal debt (measured as total interest payments as a percent of GDP) today is about as low as it has ever been, even though total debt as a percent of GDP is higher than it has ever been (save for the WW II years). The circle is squared by the level of interest rates, which remain very near all-time historic lows. The blue line on this chart is virtually certain to start rising within the next year as market interest rates rise—as they must, given the huge rise in inflation shown in the following charts.

Chart #9

Chart #9 plots the level of the CPI index ex-energy on a log scale. Here we see how inflation by this measure has averaged just about exactly 2% per year over the past two decades. But note how the index jumps in the past several months above trend. The year over year rate has been boosted to a degree due to the dip in the level of the index in April and May of last year (the so-called "base effect"), but that dip was fully reversed by August last year. What we've seen in recent months is a mini-boom in the index above and beyond its long-term trend growth rate. This makes me think that rising inflation is not just transient. But tell that to the Fed, whose members are inordinately afraid to pull the punchbowl this time around, after doing so prematurely too many times in the past.

Chart #10

Chart #10 looks at the 6-mo. annualized change in the CPI (both with and without energy) to get a better idea of what has happened since the very weak CPI data in the first half of last year. By this measure inflation is running at a 4-6% annualized rate. And even higher—prices are up at a 7-8% annualized rate over the past 3 months! All of this is very reminiscent of what happened to inflation in the mid 2000s when it gradually became obvious that the Fed had failed to tighten policy sufficiently. And when they did manage to tighten policy we ended up with the Great Recession which began in 2008. I would further note that the 10-yr Treasury yield rose from 3.5% in 2003 to a high of 5.5% in 2006. We could easily see a repeat of this in the years to come. Beware fixed income bonds.

It's hard to believe, but today the 10-yr Treasury yield is a mere 1.4%, which is way less than the current rate of inflation. Way less. The entire Treasury curve is well below the current rate of inflation, which means that Treasuries are generating losses in real terms that are on the order of $0.5-0.7 trillion per year (and possibly more). Uncle Sam doesn't mind, though, since he is the world's biggest debtor. (The debt holder's loss is the debt issuer's gain.) Uncle Sam is currently benefiting from a "stealth" tax which is otherwise known as an inflation tax, and it's generating a not insignificant amount of money—much more than all corporate income tax receipts.

Wednesday, June 9, 2021

The good, the bad, and the ugly

On the surface, conditions in the US look pretty fantastic these days. Prices for lots of goods and services are soaring. Job openings are at record highs. Financial markets are awash in liquidity, and financial market conditions in general are about as good as they have ever been. Debt service burdens for most people are at all-time lows. The stock market is on the cusp of new all-time highs. Corporate profits are booming. Air travel is surging. The economy has recovered just about all it lost to the Covid-19 crisis. Household net worth is at all-time highs in nominal, real and per capita terms. Private sector jobs have recovered almost 70% of what they lost due to the Covid-19 shutdown. Vaccines and natural immunity have all but vanquished Covid-19. Conditions are improving daily, with no near-term end in sight. On the inflation front, expectations currently remain reasonably anchored at around 2.5%.

We are not free of problems or worries, of course. Is Biden of sound mind and body? Is Kamala capable of running the country? Will Congress pass, by the thinest of partisan margins, another round of trillion-dollar spending boondoggles and a permanent and massive expansion of the welfare state? Will the Fed wait too long to reverse its enormous QE efforts? How many of the 10 million workers currently sitting on their hands will want to return to work when emergency unemployment benefits expire in a few months? How long will it take for the Fed to boost short-term rates to a level that once again offers a positive real rate of return? What will happen, in the meantime, with the nearly $5 trillion in savings that have accumulated in the banking system since March 2020? Does the historically low level of real risk-free yields on TIPS suggest that US economic growth will be anemic at best for as far as the eye can see? Are equity valuations dangerously over-priced?

My sense of the news is that several potentially worrisome initiatives are now unlikely to prevail. Thanks to the opposition of the G7, Biden's proposal to unify and raise corporate tax rates to a higher level is dead; instead, the best he can hope for is an agreement to create a new, lower minimum tax rate (15%) that is uniform among developed economies. Even that looks dodgy, however. Senator Manchin appears to be standing firm against nuking the filibuster. Biden's spending plans, which are looking more extreme by the day, are facing growing pushback among the saner elements of his party. 

As for the ugly, the Libertarian-leaning Tax Foundation recent issued a report that says Biden's tax hikes and spending proposals (billed as all-in stimulus) would in fact hurt the economy (the WSJ has more details). I agree: Biden's tax and spend agenda is the last thing this economy needs right now.

The charts that follow flesh out several of these arguments and developments. In the end, I remain near-term bullish but still quite worried about the potential for 1) higher-than-expected inflation down the road and 2) more outrageous and destabilizing fiscal "stimulus" and tax-hike proposals, all of which could end up derailing what for now is looking like a classic boom-type recovery.

Chart #1

Chart #1 illustrates the bizarre developments in the labor market. Many millions of people have returned to work, but there are still millions more on the sidelines. The number of job openings has exploded because employers are unable to find workers who want to work. The obvious culprit is the emergency unemployment benefits which create an enormous incentive for people to remain unemployed until these benefits expire in early September. While this is mostly a temporary problem, it is unnecessarily holding back the recovery and continuing to balloon the deficit. 

Chart #2

Chart #2 has both good and bad news. Good: more companies are looking to increase their hiring than ever before. Bad: There's a huge shortage of willing workers which is stymying efforts by millions of companies to grow. 

Chart #3

Chart #3 illustrates the dramatic improvement in airline passenger traffic. However, the number of people passing through US airports is still about 30% below the prevailing levels at this time in 2019. 

Chart #4

Small businesses employ the lion's share of US workers, so it is concerning that their confidence has sagged from the heady levels of the Trump years, as Chart #4 shows. Undoubtedly several factors are at work: emergency unemployment benefits which pay people not to work, the prospect of rising tax rates on corporate profits and individual incomes, renewed growth in regulatory burdens, and the knowledge—which will not soon fade—that state and local officials can turn off their business at a moment's notice should a new virus surface. 

Chart #5

As Chart #5 shows, the number of private sector jobs today is about 7 million less than where they would have been if the prior trend had continued. Public jobs are more than one million less than they were pre-pandemic. Yet despite these huge job losses, real GDP today is at least as high as it was prior to the Covid shutdowns. That means that the productivity of those who have been working has shot up dramatically, as the economy was forced to find ways to produce more with fewer people. We've seen a revolutionary advance in productivity thanks to Covid. As millions of currently idled workers find there way back into the workforce, that will give GDP growth a significant boost lasting at least through year end.

Chart #6

Chart #6 is quite sobering. Prior to the Great Recession, the labor force (defined as all those of working age who are employed or looking for work) was growing at a rate of about 1.2% per year. Since then, growth in the labor force has been anemic—more so than ever before. I calculate that there are about 19 million fewer in the labor force today than there would have been at the prior trend growth rate. That's a lot of idled human capacity.

Chart #7

Chart #7, Bloomberg's Financial Conditions Index, today is about as high as it has ever been. This all but rules out a near-term recession or even a growth pause. Liquidity is abundant, credit quality is excellent, and nerves have calmed.

Chart #8

Chart #8 shows corporate credit spreads. Today, spreads are about as low as they have ever been, which is a sign that the market is quite optimistic about the outlook for economic growth and corporate profits. One factor contributing to this is the abundance of liquidity and the Fed's pledge that it will not tighten monetary conditions for a long time. Not only does this limit downside economic risk, but it also adds to inflationary pressures down the road, and inflation is something that generally benefits debtors.

Chart #9

Chart #9 is my indispensable tool for judging the likelihood of recession. With the exception of the Covid-19 shutdown/recession, every other recession on this chart was preceded by 1) a flattening or inversion of the Treasury yield curve (red line), and 2) a high and rising real Federal Funds rate. Today the yield curve is steepening, much as it has always done during growth cycles, and the real funds rate is as low as it has ever been. This adds up to an extremely low probability of recession for the foreseeable future.

Very low real yields, such as we have today, are not an unalloyed boon, unfortunately, since they weaken the demand for money (while also actively encouraging borrowing and spending), and thus this can be harbinger of rising inflation if the Fed does not take steps to a) reduce the supply of money by reversing its QE actions and b) boosting short-term interest rates. High and rising inflation would dramatically increase the likelihood of Fed tightening and eventually lead to another painful recession. That risk is not yet imminent, however, but it is certainly worth keeping an eye on.

Chart #10

Chart #10 shows an index of non-energy spot commodity prices. Prices have soared, beginning right around the time—in late March—when federal government started pumping trillions of dollars into the economy to offset the effect of shutdowns, and the Fed ended up buying almost all of the debt that was issued, thus massively expanding the money supply. How much of the increase in prices is due to monetary inflation, and how much to the economic recovery and increased demand for goods and services which had suddenly become in short supply? 

Chart #11

I've been featuring Chart #11 often over the past year, since I think it illustrates something that almost all commenters have either ignored or forgotten. The chart shows the percentage of annual income (GDP) that is held in cash or cash equivalents (M2); as such it is a good measure of money demand. As all economists should know by now, the balance between money supply and money demand is of crucial importance. When the supply of money exceeds the demand for it, inflation is the result. The Fed's massive increase in the money supply last year was matched by an equally massive increase in money demand—that's why inflation was low last year. More recently, it looks like money demand is beginning to soften. That makes sense, given the fading of the Covid crisis and the return of confidence. Yet the Fed has done nothing to reverse its massive increase in the money supply. That's why inflation has begun to rise at a troubling rate in recent months (see Charts #9 and 10 in my last post). 

The future course of inflation is of the utmost importance, yet most observers, including the Fed, insist that the recent rise in inflation is transitory—inflation has increased solely because demand has outpaced supply of late and supply eventually will catch up. That's probably true in part, but I think the more important explanation is that the Fed has allowed (and even encouraged) the demand for money to decline without taking offsetting action to either reduce money supply or boost money demand. 

Chart #12

Chart #12 compares the M2 money supply to nominal GDP. For many years they tracked each other closely. But now we've seen an unprecedented surge in M2 that has so far not been matched by a similar pickup in nominal GDP, (both nominal and real GDP today are above their pre-Covid highs, but have not yet exceeded their pre-Covid trend growth rate). In the absence of a concerted attempt by the Fed to reduce the money supply, I would expect to see nominal GDP pick up significantly in future years, with most of the pickup coming in the form of rising prices. There is an awful lot of potential inflationary fuel out there, and it only needs only a return of confidence and a laggard Fed to ignite.

Chart #13

Chart #13 compares the 2-yr annualized growth rate of real GDP (red line) with the real yield of 5-year TIPS. (I've assumed that GDP growth in the current quarter will be an annualized 7%.) Not surprisingly, these two variables tend to track each other. Strong GDP growth is consistent with generally high real rates, and weak growth with low real rates. The current level of real yields is about as low as we have ever seen. I can only think that is because market participants expect the long-term rate of GDP growth to be generally anemic. Perhaps it's not a coincidence that Biden's recently proposed budget in fact assumes that despite many trillions of fiscal "stimulus" coupled with rising tax burdens the economy's rate of growth over the next decade will average only 1.7% per year, substantially lower than anemic growth of the Obama years (2009-2017), when growth averaged a little over 2% per year (the weakest recovery on record). 

Chart #14

Chart #14 compares the real Fed funds rate (blue line) to the real yield on 5-yr TIPS (blue line)—the latter being the market's expectation for what the blue line will average over the next 5 years. When the blue line is below the red line, that indicates the market is expecting the Fed to increase its real funds rate target in the future, which is generally the case in normal times. When the blue line is higher than the red line, this is the market saying that the Fed is too tight and is thus likely to have to ease policy in the future. Looks to me like the Fed is plenty easy these days. 

For practical purposes, a very negative real yield on cash and cash equivalents such as we have today (the blue line being a good proxy for cash yields) creates powerful incentives for people to borrow money and spend it. Why? Because borrowing at a negative real rate during a period of rising prices means you don't have to take on much risk in order to make a profit, since the price of most anything you buy will rise while your debt burden—which costs little or nothing to maintain—will shrink. Another way of looking at it: negative real rates strongly discourage people from holding money (i.e., it erodes money demand) and strongly encourage them to spend money. There's an awful lot of money being held these days which is steadily losing purchasing power. If the Fed doesn't reverse its QE efforts, unwanted money will find its way into higher prices.

Chart #15

Chart #15 compares nominal and real yields on 5-yr Treasuries, with the difference between the two (green line) being the market's expectation for the average annual increase in the CPI over the next 5 years. Note the significant pickup in inflation expectations that has occurred since March '20, when the market only expected inflation to average 0.2% per year. That expectation has now jumped to 2.5%. That's not particularly troubling, but it does represent a huge change.

Chart #16

Chart #16 shows the monthly history of the S&P 500 index of equity prices since 1950. As the chart shows, equity prices have increased by an annualized 7% per year over this 70+ year period. Add dividend yields to this, and you get an annualized total rate of return on equities of about 8.5% per year. There's a lot of variability along the way, to be sure, but a buy-and-hold strategy generally pays off handsomely. Note that the 7% trend line shows just about as many above-trend years as below-trend years. If anything, I take this to mean that the equity market today is not necessarily in a "bubble" like it was in the years leading up to 2000. 

Wednesday, May 19, 2021

The Fed and our politicians are playing with fire


Beware the monetary and fiscal misunderstandings that proliferate these days. 

There are two reasons to expect higher inflation now and in the future, and monetary "stimulus" is not one of them. There is no reason to expect that all the fiscal "stimulus" spending being contemplated in Washington will do anything good for the economy. The government cannot possibly spend money more efficiently and productively than the private sector. Raising taxes on the most productive members of society cannot possibly make the less productive members better off. 
 
Monetary policy can be "stimulative" only to the extent that it is neutral—i.e., neither too lose nor too tight. The Fed can't create growth and prosperity by printing more money, but it can hobble growth by being too tight or too lose; bad monetary policy introduces distortions to the economy that only work to slow growth. To the extent monetary policy is predictable and focused on preserving the value of the dollar it can be a factor which promotes growth by instilling confidence in the future and thus encouraging investment. But artificially low interest rates (which many claim we have today) do not necessarily make the economy stronger. On the contrary, keeping rates artificially low encourages borrowing and spending and discourages investment. Investment is the key to growth, not spending or demand—this is the central insight of supply-side economics.

Long-time readers will know that I have for years argued that Quantitative Easing was not stimulative. Instead, I saw it as a response by the Fed to the economy's demand for additional cash and cash equivalents. That demand, in turn, was created by the extraordinary bouts of uncertainty that have buffeted the economy since the Great Recession of 2008-09. By engaging in QE, the Fed was simply responding to an increase in money demand by transmogrifying notes and bonds into bank reserves (which pay a floating rate of interest and are default-free, just like T-bills). I have pointed out that the huge increases in the M2 supply that we saw in the late 2000s and early 2010s were not inflationary because the Fed was essentially converting notes and bonds into cash equivalents, which in turn was necessary to avoid a shortage of money. When the Fed adds money to match an increase in money demand, it is not inflationary; inflation only happens when the supply of money exceeds the demand for it.

I am now arguing that we are in the early stages of a monetary policy mistake that the Fed is committing. Last year the Fed boosted M2 by over $4 trillion in response to the unprecedented, catastrophic and extremely costly shutdown of the US economy. That was fine then, but it's not fine now. The economy is rebounding, confidence is returning, fears have eased, and the demand for money is consequently no longer increasing and in fact is decreasing. But the Fed is not reversing its QE in response, and so unwanted money  is accumulating. That shows up in dollar weakness, rising commodity prices, rising housing prices, and rising inflation expectations. Lots of unwanted money is likely helping stock prices to rise as well. 

If monetary policy is too easy or too tight, that affects the current and future value of the dollar, and the future thus becomes less certain. Uncertainty is the enemy of investment, and investment is the source of growth and prosperity. An uncertain future inhibits growth by encouraging investors to choose safety over risky ventures which promise to enhance productivity and living standards. As my mentor John Rutledge used to say, inflation is like a thick fog that settles on the highway, forcing everyone to slow down. Deflation is just as bad. A strong and stable dollar is nirvana. Huge increases in the money supply coupled with massive deficit-fueled government spending is most definitely not nirvana. It's time to get very worried that policymakers are going to be too slow to respond to the huge improvement in the economic outlook.

In the charts that follow I first cover the state of fiscal policy, which has deteriorated like never before. Spending is essentially out of control and off the charts. The Fed used the avalanche of new Treasury debt (about $4 trillion in just the past year) as an excuse to massively grow its balance sheet. Reckless spending and easy money are a very bad combination that will feed future inflation and slow the economy—unless they show clear signs of reversing soon.

At the onset of the Covid crisis, it all made sense. Fear skyrocketed and the demand for cash exploded. Everyone wanted to hold more cash (currency, checking accounts, demand and savings deposits) in order to protect against the unknown consequences of shutting down the global economy overnight. Those who didn't lose their jobs were unable—and likely unwilling—to spend all the money they were making. The Fed had no choice but to balloon its balance sheet in order to supply more cash and cash equivalents, and the federal government had no choice but to replace the incomes that were lost by an army of unemployed due to the arbitrary and sudden shutdown of the economy.

The Covid-19 pandemic is essentially over, at least in the US, since we have by now effectively achieved herd immunity via vaccines and antibodies. With the economy rapidly rebounding and confidence returning by leaps and bounds, the Fed is failing to reverse its money creation efforts, and unwanted money is thus flowing into other and better stores of value. Indeed, the Fed keeps insisting that it won't need to reverse course for a very long time! (Although the April FOMC minutes—released today—did acknowledge that eventually they will have to do so.)

Compounding these problems, politicians—looking to assuage their guilt over unnecessary shutdowns and quite possibly with an eye on future elections—voted for a significant boost in unemployment benefits. So much so that many millions of workers have realized they are better off staying at home rather than returning to work. But it's important to remember that supply bottlenecks and temporary labor shortages are not what create inflation: only Fed mistakes do. And it's also the case that this issue—excessive unemployment benefits—is already fading, since the extra benefits are set to expire by September and meanwhile, a growing number of states have decided to cancel those benefits.

What should be obvious to investors is that there is a significant cost to holding cash. Holding cash or most cash equivalents these days—and probably for the next two years—is almost certainly going to result in the loss of 3% or more in terms of purchasing power per year, because cash pays zero interest. And there is a lot of extra cash out there that is wasting away in bank savings and deposits—over $4 trillion, according to the M2 measure of the money supply.

So there is a compelling reason these days to avoid cash if at all possible. And, given the extremely low level of interest rates and spreads, investors should also avoid most fixed income instruments as well, because interest rates inevitably will rise and bond prices will decline significantly even if future inflation is only 2-3% per year.

For better or worse, and it's no surprise, the market has already begun to reprice along these lines. Inflation is fully expected to average almost 3% per year (2.7% is the market's current expectation) for the next 5 years, according to the TIPS market. Housing prices have risen dramatically all over the country. Used car prices have exploded. Commodity prices are soaring. The dollar is hovering around its weakest level in the past 5 years. All these indicators are consistent with there being a surplus of dollars in the world. Simply put, the value of the dollar is declining, and rising inflation is the natural counterpart to a weakening currency.

As for housing, affordability is the key factor driving housing prices, and this is unlikely to deteriorate any time soon. If mortgage interest rates remain low, prices will continue to climb until they become unbearable. But meanwhile, incomes will be growing as well, so current conditions could continue for a few more years. But at some point, higher rates could easily pop the inflating housing bubble.

What to do? No easy solutions present themselves. It’s not obvious how all this will play out; there are too many variables involved to make confident forecasts. Beyond, that is, predicting that lots of purchasing power and bond market valuations will be eroded with the passage of time. Big debtors, especially the US government, will benefit. Creditors in general will suffer, as will those in the private sector that have behaved responsibly by avoiding risky investments and holding onto “safe” cash. These processes are well underway. Very unfortunately, this all adds up to a significant headwind to future growth. Things may look fairly rosy right now, but over the long haul there could be significant problems. This realization may well explain why real interest rates on Treasuries are incredibly low.

Furthermore, it’s not unreasonable to think things could spin out of control. You can’t play fast and loose with the value of the world’s most popular currency without sowing negative seeds. The Fed may be forced to go back on its word and tighten well in advance of what they are promising today, and this could result in havoc for many markets. Meanwhile, the Fed is risking its credibility daily, and that is not good.

At the very least, a sooner-than-expected Fed tightening could lead to another round of panic such as we saw in late 2018. In retrospect, it is clear that the Fed back then had been tightening preemptively (unnecessarily worrying about higher inflation). That’s probably why they are so anxious to avoid tighening again—probably until it becomes painfully obvious that a tightening is necessary. And by that time, it’s likely they will have to tighten by more than they and the market would like. And that is exactly what has preceded and triggered nearly every recession in my lifetime. It's all so unfortunate.

The charts that follow give you a snapshot of the origins of the mess we find ourselves in today. Massive government spending and an overly-accommodative Fed have introduced profound risks to the economy and to financial markets.

Chart #1

Chart #1 shows the 12-month running total of federal government spending and revenues. Spending has literally exploded, while tax receipts have been growing quite slowly for the past 5-6 years. This is not a sustainable situation.
 
Chart #2

Chart #2 shows federal government spending and revenues as a percent of GDP. Spending stands out starkly as unprecedented, while revenues are only moderately below long-term averages.

Chart #3

Chart # 3 shows the 12-month rolling sum of monthly budget surpluses and deficits. The only other time deficits have been this large was during World War II. At least back then we had something to show for the spending: world peace and global growth. Today we have done little more than take trillions from the pockets of the more productive only to put it into the pockets of the less productive. Income redistribution on a massive scale cannot possibly lead to a growing and productive economy.

Chart #4

Chart #4 shows federal debt held by the public, which you can find here. Please note that the best measure of the debt outstanding is "Public Debt," i.e., debt held by the public. This does not include intragovernmental debt. If it did, that would be double-counting. 

Chart #5

Chart #5 shows total federal debt as a percent of GDP. It's huge in nominal terms, and almost as big relative to GDP as it was during WWII. In the aftermath of WWII debt shrunk rapidly relative to GDP, mainly because economic growth was spectacular. Although growth in recent quarters has been exceptionally strong, this is unlikely to be the case for the rest of this year and next. Why? Because last year's huge increase in debt was not put to productive use, as it was during WWII. 

Chart #6

Chart #6 shows the true burden of federal debt, which is defined as debt service costs relative to GDP. Although the debt is huge in nominal terms, interest rates are historically very low, with the result that servicing the debt only requires a modest 2.5% of GDP per year. This is very likely to increase in coming years as interest rates rise, even if annual budget deficits decline, but the increase is going to be slow (i.e., it doesn't present an imminent or dangerous risk for the next few years—we have time to get things fixed).
 
The following charts have important information about the money supply and inflation.

Chart #7

Chart #7 compares the nominal growth of GDP and M2 over the past 60 years. There is enough money in the wild today to support an enormous increase in nominal GDP. If people decide they are holding more money than they feel comfortable with, the current M2 money supply could quickly translate into a huge increase in nominal prices. In other words, the Fed has already supplied the fuel for a whole lot of inflation if the market's demand for money declines.

Chart #8

Chart #8 shows my preferred measure of money demand, which is M2 as a percent of GDP. This is akin to measuring how much of the average person's annual income he or she wants to hold in the form of cash and cash equivalents. As should be obvious, money demand has skyrocketed in recent years, and it's never ever been as high as it is today. The Fed last year purchased trillions of dollars' worth of newly-issued federal debt. The vast majority of the increase in M2 came in the form of bank savings deposits. Banks effectively invested strong savings inflows into bank reserves, which are functionally equivalent to T-bills. As a result, banks have a supply of bank reserves that is orders of magnitude more than would normally be required to collateralize their deposits. Should banks find more attractive lending opportunities in the private sector, the Fed's current provision of bank reserves would be sufficient to facilitate a further enormous increase in the M2 money supply ($1 of reserves is typically required for every $10 of deposits).

Chart #9

The Fed would like us to believe that the big (and surprisingly large) increase in consumer price inflation over the past year is just a temporary phenomenon. While it's true that the rise in prices in March and April of last year was depressed by the Covid shutdown, that's not necessarily the reason for the outsized jump in prices in the past two months. Chart #9 tries to illustrate this, by comparing the CPI index to its long-term 2% per annum trend, using a semi-log scale. If the jump in recent inflation were just payback for the slump a year ago, the current level of the CPI index would not be above it's long-term trend. But it is.  

Chart #10

I think it's fair to say the current rate of inflation is best measured using the seasonally adjusted trend of the past six months, which you can see in Chart #10. Overall inflation is up at a 5% annualized rate over  the past six months, while ex-energy inflation is up at a 3.1% annualized rate. A casual observer might say that we're already living in a 4% inflation world, which is double what we've seen in the past two decades.

Chart #11

National average home prices are up well over 10% in the past year, and rising. In inflation-adjusted terms, home prices today are as high as they were at the peak of the housing market bubble in 2005. But back then fixed rate mortgages were going for 5% or so, whereas today they are only 3% or so, as you can see in Chart #11.

Chart #12

Despite recent price increases, very low interest rates and abundant supplies of cash have conspired to make housing very affordable, as you can see in Chart #12. In fact, house prices today are much more affordable for the average family than they were in 2005.

Chart #13

Chart #13 shows why house prices are likely to continue to rise. The supply of unsold homes on the market today is just about as low as it has ever been. It's a huge seller's market, with lots more willing buyers than sellers. Prices could continue to rise even if mortgage rates increase by another percentage point or so.

Chart #14

Chart #14 compares the level of the dollar (inverted) to an index of the prices of industrial metals. The dollar is at its weakest level in the past 5 years, and a weak dollar can help explain why commodity prices are up (i.e., there is a fairly reliable correlation between dollar weakness and commodity price strength, and vice versa). But the recent gains in commodity prices look pretty impressive nonetheless. There must be a lot of demand for physical stuff, and that is likely fueled by the perception that with lots of money earning zero interest, it's better to be buying physical assets (which tend to rise with inflation) than it is to be buying financial assets such as bonds. Cash is trash.

Chart #15

Chart #15 shows there has been a rather impressive rise in consumer confidence since last summer. The US and Israel have basically won the fight against Covid, thanks to vaccines and acquired immunity. Other nations are working hard to catch up. The economy is throwing off its mask and people are getting back to work, anxious to live a normal life again. Who needs a huge stockpile of cash when the future looks so much brighter now than it did just six months ago?

Chart #16

Chart #16 shows the level of traffic passing through US airports since the Covid crisis began 14 months ago. The current level of traffic is still about 35% below the levels of two years ago (when it was about 2.5 million per day), but at this rate it won't take much longer to be completely normal. Things are improving rather rapidly these days. 

How long will it take the Fed to realize all this? How long will it take our politicians to realize that massive fiscal stimulus is not only no longer needed, but actually problematic and quite possibly dangerous?

Too much monetary and fiscal "stimulus" is quickly becoming a toxic brew and cause for great concern.