I have been having long debate about inflation. I was scratching my head trying to figure out what was going on. Given governments around the world printing historic amounts of money, the natural result should be inflation. Economic output is down. And yet, it took time to see it.
Now inflation has been higher for the last several months in the U.S. and many other nations. In fact, U.S. prices are a lot higher. We are seeing increases in the consumer price index (CPI) rise to its highest level in 30 years. The press is finally awakening to the issue.
So, inflation is here, and more is coming. But is it transitory? Is it a result of supply chain disruptions? Trade wars with China? Or is it something else? While these factors are not helpful and can create some inflation, it is very likely something else.
The quantity theory of money (QTM) holds that the exchange value of money is determined like any other good, by supply and demand. The basic equation for the quantity theory is called The Fisher Equation. In its simplest form, it looks like this:
Money supply (M) x Velocity of Money (V) = Average Price Level (P) x Volume of Transactions (T)
So:
M x V = P x T
The idea of the QTM is that if you double the money supply and money changes hands at about the same rate then you get 100% inflation. This elegant equation makes a lot of intuitive and pragmatic sense. Prices are linked to the money supply and economic activity, which results in prices for the goods and services we buy going up or down.
But we are in strange times with the pandemic. We know two things for certain. The pandemic reduced a lot of spending and economic activity in many areas and sectors, and governments created massive amounts of spending to fund consumption by printing money.
But just how much money printing has gone on. Let’s look at the U.S., as the international reserve currency it plays a very important role in global finance. How much money did the U.S. print from March 2020 to October 2021?
The Federal Reserve printed trillions during the pandemic. In fact, 14,000,000,000,000 dollars were printed between March 2020 until the end in January 2021 alone. And the printing continues. As the chart below shows, most of it was printed in April and May 2020. This was probably to prop up the financial markets. But it was supported, if not directly endorsed, to allow the then incumbent president a reasonable chance at re-election. Whatever the reason, economic, market-driven, or otherwise, the money supply increased 12 Trillion dollars between April and May 2020 in the U.S. alone. The U.S. money supply was almost quadrupled in about one month.
The new U.S. federal administration has continued the trajectory of money printing, but nothing compared to the spectacular April super money dump.
Even with new money flooding in, we know that the economic impacts from the pandemic dropped spending, and economies contracted significantly. For example, the U.K. was hit particularly hard with a 10% drop in GDP. But imagine the devastation in Macao, heavily focused on hotels, tourism, and casinos with more than a 50% drop in GDP, even with massive government spending which is included in the calculation of GDP. So the impact on GDP was even greater because government spending is part of GDP. Economic output is down in the pandemic, money supply is up. So, why has there been a delay in inflation hitting? It has a lot to do with behavior.
The Covid-19 pandemic led to fear and greatly reduced spending and economic activity. Many people received government support and rent relief and other payments. The result was a reduction in high interest debts, such as high interest credit cards. It did not so much provide “stimulus” to spur consumption in the economy, but to prevent systemic collapse. The impact of the pervasive fear and mandated closures resulted in a historic slow down in the velocity of money.
In simple terms, the barber was closed so he could not buy bread. The baker did not sell bread, and then did not go to on movies. The movie theatre owner was closed and did not go on a vacation. The hotel was closed so the owner did not need to visit the barber because she did not have any guests. The pandemic created a negative feedback loop for the velocity of money, which compounded on itself. In the U.S. the velocity of money reduced by approximately 73% during the pandemic from over 5 and now still sits at historic lows. But just how low?
Very, very, very low. The velocity of money stands at 1.10. And this is the real problem.
Velocity of money is really related to consumer behavior (or sentiment) whereas the money supply is a real thing that exists in the world. To change the velocity of money people can just change their minds, whereas the money supply is here to stay and must be burned or otherwise destroyed to change it. One could simply suggest that the money supply be reduced when spending resumes, but if history is a guide, then a significant reduction in the money supply would likely trigger a recession. Moreover, the history of central banks shows that money supplies have increased for decades, and reducing them is painful and hard to do, if it is possible at all. Reducing the money supply is an easy way to create a recession.
So as consumer spending returns to any normal level we should see massive inflation, because behaviors may change, and the money supply will remain at record high levels. Why is this? If people think prices are going up, what do you do? Obviously, buy now so you can pay less. If prices are going up, better get in fast to avoid higher prices later. And so, the velocity of money can, and likely will, change fast.
Unfortunately, when the pandemic recovery truly comes, then we should expect inflation. There will be lots and lots of inflation in the U.S. and all other linked countries, assets, and USD-pegged currencies. Unfortunately, we could very well see hyperinflation in many parts of the G20 and globally. If the velocity of money returns to anywhere close to pre-pandemic levels, inflation will quickly hit in a massive way.
That can of coca cola that cost a $1 dollar in 2020, may cost you $5 in 2022. All things, products and services will cost more, and that just makes sense. This is because the U.S. has increased its money supply by over 400% and shows no sign of slowing down. So, if you think the pandemic is over, it is not. The economic hangover from the profligate spending and money printing in April 2020 will likely linger long into 2022 and beyond.
So, what can 16 Trillion dollars buy you? Time. It does not change the situation but will likely have made the global economic situation much, much worse. And this is just at the time governments want to borrow more to invest in infrastructure and to combat climate change and promote sustainability.
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Note: These are my own, personal opinions on macroeconomic conditions and may change with additional evidence or data without notice to you. I am not providing financial advice and this should not be relied upon. Please seek your own financial advice and a qualified financial advisor. The research listed and the personal opinions expressed here do not reflect the opinions of any organization or entity, including, but not exclusively, Resolution Investment Management, which is a division of ReSolve Asset Management.