Friday, September 24, 2021

Your cash will lose at least 5% of its purchasing power in the next year

Earlier this week, Fed Chair Jerome Powell announced that the real yield on dollar cash and cash equivalents is likely to be -5% or less over the next 12 months. Yes, your cash balances will lose at least 5% of their purchasing power over the next year, and that's virtually guaranteed. So what are you—and others—going to do about it?

Assumptions: This forecast of mine optimistically assumes that 1) the first Fed rate hike of 25 bps comes, as the market now expects, about a year from now, and 2) the rate of inflation slows over the next 12 months to 5% from its year-to-date rate of 5.9%. Personally, I think inflation next year likely will be higher, if only because of the delayed effect of soaring home prices on Owner's Equivalent Rent (about one-third of the CPI), the recent end of the eviction moratorium on rents, and the continued, unprecedented expansion of the M2 money supply.

I'm a supply-sider, and that means I believe in the power of incentives. Tax something less and you will get more of it. Tax something more and you will get less of it. Erode the value of the dollar at a 5% annual rate and people will almost certainly want to hold fewer dollars than they do today.

I'm also a monetarist, and that means I believe that if the supply of dollars (e.g., M2) increases by more than the demand for dollars, higher inflation will be the result. We've already seen this play out over the past year: the M2 money supply has grown by more than 25% (by far an all-time record) and inflation has accelerated from less than 2% to 6-8%. Massive fiscal deficits have played an important role in this, but so has an accommodative Fed. Between the Fed and the banking system, 3 to 4 trillion dollars of extra cash were created over the past 18 months. At first that was necessary to supply the huge demand for cash the followed in the wake of the Covid shutdowns. But now that things are returning to normal, people don't need or want that much cash. Yet the Fed continues to expand its balance sheet, and they won't finish "tapering" their purchases of notes and bonds until the middle of next year. That means that there will be trillions of dollars of cash sitting in retail bank accounts (checking, demand deposits and savings accounts) that people will be trying to unload.

If we're lucky, the inept and feckless Biden administration will be unable to pass its $1.5 trillion infrastructure and $3.5 trillion reconciliation bills in the next several weeks. This will lessen the pressure on the Fed to remain accommodative, but it's not clear at all whether it will encourage the Fed to reverse course before we have a huge inflation problem on our hands. Non-supply-siders (like Powell) view an additional $5 trillion of deficit-financed spending as an unalloyed stimulus for the economy. Supply-siders view it as a virtually guaranteed way to increase government control over the economy and thereby destroy growth incentives and productivity.

Amidst all this potential gloom, there are some very encouraging signs, believe it or not. Chief among them: household net worth has soared to a new high in nominal, real, and per capita terms. Also, believe it or not, the soaring federal debt has not outpaced the rise in the wealth of the private sector. See the following charts for more details:

Chart #1

Chart #1 is a reminder of just how low today's interest rates are relative to inflation. Terribly low! In normal times, a 4-5% inflation rate would call for 5-yr Treasury yields to be at least 4-5%. yet today they are not even 1%. The incentives this creates are pernicious: holding cash and/or Treasuries implies steep losses in terms of purchasing power. That in turn erodes the demand for cash and that fuels more spending and higher inflation.

Chart #2

Chart #2 shows the growth of the non-currency portion of M2 (currency today is about 10% of M2). Currency in circulation—currently about $2.1 trillion—is not an inflation threat, because no one holds currency that they don't want. The rest of M2, just over $18 trillion, is held by the public (not institutions) in banks, in the form of checking, savings, and various types of demand deposits. For many, many years M2 has grown at an annual rate of 6-7%. But beginning in March of last year, M2 growth broke all prior growth records. As the chart suggests, the non-currency portion of M2 is about 25% higher than it would have been had historical trends persisted. That means there is almost $4 trillion of "extra" money in the nation's banks. This extra money has been created by the same banks that are holding it: banks, it should be noted, are the only ones that can create cash money. The Fed can only create bank reserves, which banks must hold to collateralize their deposits. Today banks hold far more reserves than they need, so that means they have a virtually unlimited ability to create more deposits. And they have been very busy doing this over the past 18 months. 

For most of the past year I have been predicting that this huge expansion of the money supply would result in rising inflation, and so far that looks exactly like what has happened. People don't need to hold so much of their wealth in the form of cash, so they are trying to spend it. But if the Fed and the banks don't take steps to reduce the amount of cash, then the public's attempts to get rid of unwanted cash can only result in higher prices, and perhaps some extra spending-related growth. It's a classic case of too much money chasing too few goods and services. And Fed Chair Powell has just added some incentives for people to try to reduce their cash balances. He's fanning the flames of inflation at a time when there is plenty of dry fuel lying around.

Chart #3

Now for some good news. Chart #3 shows the evolution of household balance sheets in the form of four major categories. The one thing that is not soaring is debt, which has increased by a mere 20% since just prior to the 2008-09 Great Recession. 

Chart #4

With private sector debt having grown far less than total assets, households' leverage has declined by 45% from its all-time peak in mid-2008. The public hasn't had such a healthy balance sheet since the early 1970s (which was about the time that inflation started accelerating). Hmmm....

Chart #5

In inflation-adjusted terms, household net worth is at another all-time high: $142 trillion. 

Chart #6

On a per capita and inflation-adjusted basis, the story is the same (see Chart #6). We've never been richer as a society.

Chart #7

Total federal debt owed to the public is now about $22 trillion, or about the same as annual GDP. It hasn't been that high since WWII. So it's amazing that, as Chart #7 shows, federal debt has not exploded relative to the net worth of the private sector. As I've shown in previous posts, the burden of all that debt is historically quite low, thanks to extraordinarily low interest rates. 

Chart #8

Chart #8 adds some color to my prior post, "What's wrong with gold?" What it suggests is that gold prices are weak today because the market is anticipating higher short-term interest rates. The red line shows the yield on 3-yr forward Eurodollar futures contracts (inverted), which is a good proxy for where the market thinks the federal funds rate will be in three years' time. Gold peaked when forward interest rate expectations were at an all-time low. Why? Because super-low interest rates pose the risk of higher inflation. With the Fed now talking about raising rates (albeit sometime next year, and very slowly thereafter), gold doesn't make as much sense because forward-looking investors are judging the risk of future inflation to be somewhat less than it was a few years ago.


Ataraxia said...

Is any cash balance warranted?

Scott Grannis said...

Cash balances should be as low as possible. Cash is no longer a store of value or a place to seek refuge from risk.

Christian S. Herzeca, Esq. said...

so I have allocated all I want to stocks (30%). have about 70% in cash since I think rates go up and I dont want interest rate risk. I am planning to do a treasury 1-10 year ladder soon, that is my plan. but you never answered the question you included in the post, Scott...what do you do? this is what I am doing since I have enough, and preservation is key...and the risk of stocks at current levels keeping up with inflation is risky (especially with a mentally impaired POTUS). so cash even at -5% yield is preservative from my analytic framework

Adam said...

It looks like your opinion rhymes with Ken's one.
If he is right, i.e. if after QE tapering banks will be more eager to lend, due to a higer rates spread, then it will push inflation even higher.

Scott Grannis said...

Adam, re Ken Fisher: I don't think I'm saying the same thing as Ken Fisher. I think that what the Fed is telling people will fuel higher inflation, because: the Fed is going to make holding cash a losing proposition, and that will convince more and more people to want to get rid of their cash by spending it to acquire other things. By weakening the demand for money without simultaneously reducing the supply of money, the Fed is incentivizing inflationary behavior.

Benjamin Cole said...

Great post.

IMHO, "labor shortages" are the tonic this country needs. I hope real wages rise, taxes on wages are cut, and the warfare-welfare complex cut in half.

Inflation? IMHO the Fed overdid it a bit.

It is curious that the problem of inflation seems largely limited to the US and not to Asia and most of Europe.

Scott Grannis said...

Benjamin: Curious? We are the only major country that has suffered a more than 25% expansion of its money supply in one year.

Carl said...

‘People’ (households and companies ultimately held by households), in the aggregate, have to hold the dollars existing in the system somehow and one has to account for the notion of ‘outside’ and ‘inside’ money.
Inside money is created through bank loans. Outside money is created through bank reserves. If the Central Bank purchases an asset from a non-bank company, it pays for the asset via the seller’s bank. It credits the reserve account of the seller’s bank with the funds, and the bank credits the account of the seller with a deposit. This money deposit will eventually ‘circulate’ but has to, essentially, end up as a deposit within the system and will exist until the Central Bank transaction is reversed. But it is not money creation in substance as the operation is simply a swap between a short term liability that already exists (short term government bill) for another short term government liability (USD). The ‘new’ USD dollar will appear in M2 but not the short term government bills so the open market operations create distortions if you follow the unadjusted M2 growth over time.
“The rest of M2, just over $18 trillion, is held by the public (not institutions) in banks, in the form of…” is not a correct statement. (my bold)
M2 includes USD tied to ‘outside-money’ monetary ‘reserves’. When looking at the growth of reserves deposited by commercial banks at the Fed (which is an easy way to see the net result on reserves (unusual movements of reserves as a result of unprecedented activity at reverse repo window, Fed to money market funds)), the growth of reserves from March 2nd 2020 to September 20th 2021 has been 2.4T. Those 2.4T new USD ended up somehow in deposits and are included in M2 and are ‘outside’ money which is already matched (use double-ledger accounting thinking) to already existing US government debt liability. This is not the type of money that can directly erode purchasing power. It is the type of money however that can induce asset inflation, something which has appeared in market values of household’s net worth numbers (in a huuuge way). The Fed has acknowledged (and real economy evidence has showed) that the real-economy transmission mechanism of easing is not directly through inflation, it is based on the theoretical ability to stimulate loan growth through increased new loan activity at commercial banks, something which hasn’t happened so far in a material way.
If still unclear or unconvinced, see the following for another perspective:
Cash on the Sidelines? - Frank K. Martin, CFA (
Bank of England Quarterly Bulletin 2014 Q1
For the ‘outside’ and ‘inside’ money aspect:
Money and Output: Correlation or Causality? - Dallas Fed

ebg investor said...

Scott, Thank you for the post, always looking forward to read it again. There is a small typo under Chart #7, which is referring Chart #8.

Certainly I see benefits to reduce my cash position, however it comforts me to keep about 1-2 years of spending in cash. How you and other readers of this blog preserve the retirement cushion to go over possible corrections?

Benjamin Cole said...


It looks like you are (mostly) right on this one.

Japan's M2 money supply grew about 14% from the start of 2020, at least according to this one source (I do not know if there are fine points to measuring Japan M2 or it this is the best source).

Europe (ECB) has had very modest M2 growth, up 3.7% since the start of 2020.

And China up about 15% since start of 2020.

Japan is in deflation as we speak, and land prices are falling for two years straight, although the stock market has held up nicely.

Europe has some inflation on the CPI, a lot on the PPI.

China very low on the CPI, higher on the PPI. Given China is run by the CCP, what the stock market and land prices do is probably not meaningful presently. I would not invest in China.

Still, if M2 governs inflation, Japan seems a puzzle. And one would expect Europe to be closer to deflation than Japan.

John Cochrane places a big emphasis on fiscal deficits, but Japan remains a puzzle there too.

But perhaps the Fed and the Congress have overdone the stimulus.

I am actually more worried about the signals being sent to American citizens:

We will tax you if you work, but give you money if you do not. The federal government can only enlarge itself, and righteously so, internationally and domestically. America faces threats from domestic subversives and foreign powers, constantly escalating.

I say, "Thank the heavens for the private sector and the American work ethic."

Scott Grannis said...

ebg: thanks for spotting that typo, now corrected. As far as preserving the retirement cushion, I have always thought it prudent to figure that, following the day I retired, I might lose as much as half my net worth. Turns out that is exactly what happened after I retired in late 2007. A little over a year later I had lost half my net worth. But I survived and I never sold anything.

Scott Grannis said...

Benjamin, re M2: Everything is relative. If M2 increases 15% but money demand increases 20%, then deflation will result. I assume that is what happened in Japan. In the US we see that M2 has increased 25%, but inflation has increased. Therefore I have to assume that money demand fell by more than M2 increased.

Scott Grannis said...

Correction to my prior: ... I have to assume that money demand rose by less than M2 increased.

Carl said...

^Some may be interested in the following link then:,M2V&scale=left,left&cosd=1990-01-01,1990-01-01&coed=2021-04-01,2021-04-01&line_color=%234572a7,%23aa4643&link_values=false,false&line_style=solid,solid&mark_type=none,none&mw=3,3&lw=2,2&ost=-99999,-99999&oet=99999,99999&mma=0,0&fml=a%2F%28%28b%2B%28c%2F1000%29%29-d%29,a&fq=Quarterly,Quarterly&fam=avg,avg&fgst=lin,lin&fgsnd=2020-02-01,2020-02-01&line_index=1,2&transformation=lin_lin_lin_lin,lin&vintage_date=2021-09-26_2021-09-26_2021-09-26_2021-09-26,2021-09-26&revision_date=2021-09-26_2021-09-26_2021-09-26_2021-09-26,2021-09-26&nd=1947-01-01_1973-01-03_1959-01-01_1959-01-01,1959-01-01

i hope the link works in this format. The graph (red line) is a classic rendition of the Fred data "M2 velocity" (inverse of 'money demand'). The blue line is a reasonable estimate of M2 velocity without 'outside money'. It helps to understand why there's been some inflation lately. Now, in order to form a conclusion about the transitory (or not) nature of this inflation phenomenon, one has to dissect the numbers and see where the 'inside money' came from recently. Hint: the sources of the recent consumer inflation have been more marked than during the 'new normal' period since the GFC but, in themselves, do not contain the seeds for a significant secular change when the dust settles down.

Benjamin Cole said...


I understand your answer, and it is probably the "right" answer.

On the other hand, your answer suggests there is no "right" level of M2 growth, it all depends on whether unacceptably high inflation results or not.

Which creates this counter-argument: "Inflation is, always and everywhere, the result of the public's inclination to hold money."

So 15% M2 growth could right, or too low (see Japan and China).

Even negative M2 growth could be "right" is the public did not want to hold money.

randy said...


The question of how much cash is prudent is of course highly dependent on 1) whether you will need to draw on your savings for living expenses in the next few years and 2) how much wealth you have. If one has enough wealth that losing half isn't crippling, that person can weather it out. If someone is living on wages for at least the next few years, they can weather it out. Investors in those situations are better off being fully invested in stocks at virtually all times. Unless you are the unicorn that can time the market that is. But I'm similar to you - even though I live on wages not investments, I still keep close to 2 years living expenses because it helps me sleep.

As a side note, the ability for a wealthier person to feel comfortable staying fully invested is a part of why "the rich get richer" faster than those less well off - contributing to income inequality. Not to argue that makes the wealthy bad - but it helps to remember what it's like to not have financial stability.

Carl said...

M2 stock growth (whether seen from the velocity or demand perspective or whatever) has been clearly decoupling from underlying nominal GDP growth for a while (an unprecedented trend which simply accelerated during the recent Covid epsiode).
This money-growth decoupling has been accompanied by a fairly well correlated decoupling between asset prices, household net worth and underlying income measures.
What does it mean (for now and the relevant investment future)?

Excessive expansion (money supply growing faster than underlying economy) of money supply (including adjusted for outside money growth) has very strongly tended to erode purchasing power. But it's not the voyage, at this part of the juncture, that i'm interested about, it's the destination.

i'd like to resolve this on a first principles basis (like Elon Musk) but i'm too stupid and have to rely on some historical analogies. Reading about the US investment landscape of 1837-1843 is being helpful, at least it seems, on the surface.

Fred said...

I think Randy is exactly right about how much cash to hold, and I would say that if I were cross-examining Scott on the witness stand, I would object to his answer as being "non-responsive." If Scott has a net worth of $20MM and he lives well below his means, he could certainly stand to lose 50% of his net worth and live off the reduced dividends of his stock portfolio without selling any stock until the market recovers. The rest of us probably need more cash to weather such storms to avoid selling stock in a bear market to make ends meet. I have enough cash to last 5 years to live comfortably so I don't have to sell any of my stocks during a prolonged bear market. If there is a bear market correction in the next year or two I will probably buy some additional stocks but right now my retirement portfolio is 80% stock funds and 20% short term bond fund (Stable Principal). I'm about to turn 60.

ebg investor said...

Randy and Scott -
Thank you for sharing your investment decisions. This blog is unique with openly sharing deep economic knowledge and connecting it to personal investments. In many ways it defines my likely successful fundamental investment strategy, which doesn't come naturally for an immigrant from former USSR. Thank you Scott for your time running this valuable education blog.