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ben bernanke, budget deficit, cpi, economics, economy, federal reserve, housing, inflation, m2, m2 money supply, milton friedman, monetary policy, money supply, Obama, politics, spending
I get a sense that the investment world has begun to discount the possibility of a significant increase in inflation over the next 1-3 years. I think it’s a pretty big mistake. The housing market appears to have bottomed out and with that, loan demand should start increasing. With a down housing market no longer dragging loan demand to the floor, what’s left to hold back inflation?
The US Federal government continues to create a massive amount of new money each year with large budget deficits. These act as a fiscal stimulus that has been roughly around 8% – 10% of GDP over the past few years. That’s a lot of new money!
Federal Reserve policies are loose. That wasn’t really much of a problem with a weak housing market dragging down loan demand, but now that housing is rebounding, I’d worry a bit more about this. The Feds totally ignored the last bubble, which started around 1998 and was exacerbated greatly by Fed policies in 2001 and 2002. What actually worries me more isn’t the “loose Fed policies” so much as the dedication to keep those policies loose until certain (perhaps unreasonable) conditions are met, such as 6.5% unemployment.
So based on all of this, I’ve become more concerned about rising inflation. I’ve been watching a few key indicators over the past several months. M2 money supply is among them. I feel like our high M2 money supply growth rate is being virtually ignored by the investment community right now, which is a mistake.
Here are the latest figures. The chart below shows the year-over-year M2 growth rate.
Might not look too meaningful at first glance, but notice we’re back at the levels seen during the bubble years and the early to mid 80′s. What’s particularly notable about this is that the late 90′s bubble years were marked by higher nominal GDP growth, whereas the current environment is not; which would suggest that having a 6% – 10% M2 growth rate is a much bigger problem now than in 1998, for instance.
If that charts seems too spikey to get a handle on, here’s a rolling 3-year average of M2 money supply, which might be more meaningful.
This chart looks even uglier than the first. Once we start to level out some of the spikes, we begin to see that the sustained long-term M2 money supply growth rate right now is actually at one of the highest points in the past 25 years. We have a 3-yr average of 5.9%, which is on par with the 6.3% peak in 2001. Except, once again, only without the economic growth of that era.
These figures, as well as the US’s massive budget deficits and the Fed’s new-found dedication to permanently loose monetary policy are frightening. I wouldn’t overreact — many commentators over the past few years have warned of hyperinflation, but that’s extremely unlikely.
In actuality, with the way our system works, what’s more likely is that inflation spikes, which then forces the Feds to suddenly raise interest rates, creating a new recession. But regardless, none of this is beneficial and I would not be shocked to see a return to the up-and-down stagflationary markets of the 1970′s.
“The housing market appears to have bottomed out and with that, loan demand should start increasing.”
What?? Why would something getting more expensive increase the demand for it?
“I feel like our high M2 money supply growth rate is being virtually ignored by the investment community right now…”
This is because M2 money supply has next to no relevance regarding inflation.
Pacioli,
Price increases in the housing market definitely help drive loan demand. All you have to do is understand the power of leverage. If I buy a home for $500K, take out $400K in debt and use $100K in equity and the price appreciates 4% next year, I made a 20% return on equity.
M2 and inflation are related, but there’s a lag between the two. You also have to consider other variables such as nominal GDP growth. I’ve shown before how inflation tends to follow surges in M2. But the bigger point here is that there is a large amount of new money supply being created, but very little growth to go with it.
If you don’t think M2 and inflation are connected, take a look at Japan over the past decade. Japan’s extremely low inflation is very well predicted by the low M2 money supply rate, that seems to persist in spite of large fiscal deficits.
Re: loan demand – I understand that your leverage argument explains price action. But it does not explain how you can conclude that loan demand increases. In your example, you owned your previous house w/ a mortgage. You then sell it to buy a new one, eliminating your previous mortgage loan and presumably originating a new one. Net-net, you still have one loan outstanding. The number of loans has not been impacted by this scenario. Thus, “loan demand” is not explained by this example.
Re: inflation following M2 surges – I am skeptical of this claim, although I do not have the data in front of me to claim that you’re wrong. I would venture that there are just as many ‘false positives’ as inflation episodes (i.e. M2 surges, and then inflation does nothing). Inflation is a credit-related phenomenon, and thus has very little to do with M2. For this reason, amid a private sector debt deleveraging, I see no credible rationale for what will drive (serious) inflation in the next, say, 3-5 years.
Re: Japan – this is interesting. I will take a look. Do you have a link to good data sources on Japanese money supply trends?
I’m not really getting your argument on money supply. It would seem to be a pretty radical proposition that large increases in money supply could not result in inflation. If I’m dictator of a nation and decided to increase the amount of currency in circulation overnight, why would prices not increase?
Are you arguing that money supply doesn’t affect inflation or that M2 is not a good proxy for overall money supply? I could see an argument for the latter, but the former would seem to be a direct contradiction of mainstream economic theories.
In the US, M2 is the best measure of money supply growth in my view. M3 is actually better, but the Feds eliminated it.
I’m not sure what you mean by ‘inflation is a credit-related phenomenon’, because M2 is affected by credit. Large increases in lending lead to increases in M2 (and M3 — though it was phased out by the Fed).
I think people don’t understand the different money supply figures very well. Monetary base and M1 are less related to inflation. Monetary base mostly measures very liquid money. For this reason, it can be a poor predictor of inflation (it can even be inversely correlated to inflation). Many commentators have been predicted “hyperinflation” based on spiking monetary base, but this hasn’t played out because monetary base is really less meaningful than it might seem. But M2 is a much broader measure that has historically, been a better predictor of inflation.
Milton Friedman said that ‘inflation is always and everywhere a monetary phenomenon.’ I don’t actually agree with Friedman on that, but at the least, it’s probably true to say that ‘inflation is normally a monetary phenomenon.’
“…increase the amount of currency in circulation overnight, why would prices not increase?”
Because there is no transmission mechanism. Look at velocity. In short, the money multiplier is a myth (as it relates to Fed reserves).
“Are you arguing that money supply doesn’t affect inflation or that M2 is not a good proxy for overall money supply?”
I’m arguing the latter. Inflation is driven by broader measures than just M2. Namely credit. While still not a perfect measure, total credit market debt is far more indicative than M2 (much less M1, MZM).
I suppose we must also agree on a definition of ‘inflation’ itself. If by that you mean CPI, then we will not be able to have a productive discussion. I think CPI is bunk. I define inflation as change in total credit outstanding, marked to market.
Here is what total credit market debt owed looks like currently. http://bit.ly/V8LJPP
It looks pretty benign in terms of inflation, considering we are just now coming out of the first deflationary episode (according to this measure) in 50+ years.
Additionally, if one does insist on using CPI (because ‘everyone else does’), now that I look at the data, as expected, it looks like M2 is a pretty horrible indicator of CPI.
http://bit.ly/T9UecK
More false positives than accurate predictions. Also look at the almost mirror image divergence in 2008-2009.
I would have to agree that it is wishful thinking to say that gunning the money supply will not cause inflation. Question: Do you think M1 or m2 would have the greatest predictive value? Since January 2010 to the end of 2012 M2 has increased by 24% (most of that in 2011 and 2012), but M1 has increased a jaw-dropping 49% in the same period.
Richard,
M2 has much more predicative value.
I haven’t found M1 as useful and monetary base is virtually worthless. Velocity of money is likewise extremely overrated (it’s a myth that velocity must increase for inflation to rise — in fact, velocity often falls during inflationary environments as people flock to illiquid real assets.)
But if you look at historically at M2 relative to other measures such as nominal GDP, you can see a definite connection. Of course, inflation tends to lag M2 money growth by 1-3 years.