It will get worse before it gets better.
By Christopher Thornberg
Consumer price inflation came in at an 8.5% growth year-over-year in March—the highest in decades. The issue is now one of the biggest political liabilities being faced by the current administration. Bond markets are slowly acknowledging the issue, and long run interest rates are starting to rise as a result. Mortgage rates just crossed 5%– the highest in a decade, albeit still low from a long run vantage point.
The question now is how far it will go. The answer is much further than we would like, because of the unwillingness of our political and policy leaders to acknowledge the obvious; they wildly over-reacted to the pandemic recession and have thus over-stimulated the economy—causing both a growing financial bubble and inflation.
A casual read of the papers offers a plethora of potential culprits for inflation. We have heard over the past year that it has been driven by supply chain problems, greedy corporations, the current administration’s green energy policies, too few manufacturing jobs and of course now the Russian military campaign on Ukraine to name but a few.
But these all miss the mark as they focus on the proximate causes rather than the ultimate one. Milton Friedman, the Nobel winning economist, famously stated that “inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
Yes, prices today are being pushed by all these forces listed as reasons for inflation, but the ability for prices overall to go up in response to price increase in some portions of the market economy is ultimately a function of the overall money supply. For example, oil prices rose very sharply at the start of 2008. Overall prices did not increase as a result, rather the increase in energy prices ultimately caused downward pressure on other prices as the overall money supply is limited.
This time oil prices are up, as are all other prices. This is a general increase in prices led by specific hotspots driven by ebbs and flows in today’s economy. Ultimately for all prices to rise at the pace we are seeing can only be explained by the growth in the money supply. How much has this grown?
According to the data from the Federal Reserve M2, our best measure of the money stock, has expanded by over 40% in the last two years. That is the highest pace of money supply growth seen in over half a century, and considerably higher even seen in the seventies.
The only solution to inflation is quantitative tightening, which will send long run rates through the roof and surely cause asset markets to sag.
The money supply increased so rapidly because the Federal Reserve has expanded its balance sheet by over $5 trillion by buying various sorts of bonds over the past two years. The Fed would defend such a decision by pointing out that this is a necessary policy for the Federal Reserve to engage in during difficult economic times given low interest rates that curtain traditional stimulative efforts that operate through the Federal Funds rate. Indeed, they might go on to point out that Ben Bernanke and Janet Yellen engaged in $3.5 trillion in QE in the wake of the collapse of the Great Recession.
But the pandemic was not the Great Recession. It was surely a tragic situation, but economically it was not as serious as the collapse of the subprime bubble and the near collapse of the US financial system that occurred from 2008 to 2010. In fact, there was no financial crisis at all this time. Outside of the swoon in the first two months of the pandemic, asset markets have bounced back remarkably. Even with the recent decline in financial markets, equity prices are still a third higher than they were pre-pandemic, home prices are up 30%, cap rates continue to fall on commercial property and loan markets look to be the strongest ever.
This is the exact opposite situation being faced a decade ago, hence there was no need to engage in QE at anywhere near this level. The proof is in the money supply. Note that the $3.5 trillion in QE then caused almost no acceleration in M2—it was just enough to offset deflationary forces in the economy.
Not this time. M2 has exploded and it shows that the Federal Reserve should have retracted their QE as quickly as they engaged in it once it became apparent that there was no financial crisis to be worried about. But they didn’t, and this excess cash caused interest rates to fall, asset markets to grow.
This in turn has caused Americans to feel significantly richer than they did a couple years ago—according to the Flow of Funds data household net worth has expanded by a cool $30 trillion in two years. This false sense of wealth is the problem at the heart of the supply problems as U.S. supply chains were simply not designed to handle this excessive level of consumer demand.
Therein lies the problem with inflation right now. The only solution to inflation is quantitative tightening, which will send long run rates through the roof and surely cause asset markets to sag. This will cause consumers to no longer feel rich, which will slow consumer demand and hence slow price inflation. But no one in these fraught political times wants the group who takes the punchbowl away just when the party is starting to be good, so instead they create silly excuses and dawdle while the inflation and bubble problems get worse and worse and the inevitable cure becomes more and more painful when it is finally applied. By the way, Milton Friedman warned us that this would happen as well.
So buckle up. Until the Federal Reserve starts to reduce its balance sheet inflation will continue to accelerate. It also means rates will rise even further regardless of the path the Fed chooses. There is no soft landing.
Christopher Thornberg is Founding Partner of Beacon Economics.