When July’s CPI report showed prices rising 0.6% m/m to bring the year-over-year inflation rate to 1.0% (1.6% excluding food and energy), inflation’s rebound from its pandemic slump quelled fears of deflation ravaging the US. But it didn’t do anything to ease a related fear: hot inflation. While no one argues July’s results are the first sign of an inflationary spiral, many point to what they see as massive Federal Reserve money printing as an inflation tsunami-in-waiting. While Fisher Investments completely agrees it is healthy to view the Fed with skepticism, we think it is crucial to note that markets move on probabilities, not possibilities. The likelihood of recent Fed actions causing prices to snowball seems quite low for now.
Those fearing inflation get the basics right: Inflation is a monetary phenomenon—too much money chasing too few goods and services, as Nobel laureate Milton Friedman famously summed up. The Fed’s various coronavirus-assistance programs did jack up broad money supply this spring. M4 money supply—a broad measure, maintained by the Center for Financial Stability, that includes all super-liquid securities that function as money—accelerated from a year-over-year growth rate of 7.15% in February 2020 to 32.03% in June. This is far and away the fastest growth rate in the series’ history, which dates to 1967, so we can see why it would spark inflation fears. Yet we also see some mitigating factors.
We aren’t here to opine on whether the Fed’s actions were appropriate, but it is worth noting that this massive money supply increase occurred during a time when most businesses were forced to close, starving them of the revenue necessary to keep paying the bills. The money created through various lending programs during the pandemic largely served to replace that lost revenue. The velocity of money—the speed at which it changes hands—more or less halted when people couldn’t shop or visit their dentist or hairdresser. So the Fed attempted to bridge the gap with an increase in supply. Whether it was too little or excessive, leaving too much money sloshing around the system, is unknowable at this point—we are merely explaining the rationale.
As you might have guessed from the above, that increase was also largely a one-time thing. The exhibit below shows the month-over-month increases in M4 over the past five years. After spiking to 11.8% m/m in April, M4 growth slowed considerably, suggesting the Fed has already begun lifting its foot off the gas pedal.
Exhibit: Month-Over-Month Growth in M4 Money Supply
Now, this doesn’t address the present possibility of excess money in the economy, and while the Fed has many tools at its disposal to mop this up when the necessary time comes, it also has a long history of waiting too long to act. But Fed errors are also impossible to predict, and we don’t think anyone’s investing strategy should depend on being able to do so. If Fed actions eventually lead to higher inflation in the longer term, investors should have ample time to read the situation and make measured portfolio adjustments, if necessary. Note, too, that higher inflation isn’t automatically bearish for stocks. On the contrary, Fisher Investments’ research shows stocks’ superior long-term returns are one of the best inflation hedges there is, and they have done quite well during many periods of faster inflation. The 1970s, known for the big 1973–1974 bear market and stagflation, isn’t the rule.
But markets focus most on the next 3–30 months and, at the moment, the conditions for galloping inflation within this period look absent, in our view. Perhaps counterintuitively, this is because of the program everyone falsely sees as Fed “money printing”—quantitative easing, or QE. The Fed doesn’t actually print money through QE. Instead, it creates electronic reserve credits, which it uses to purchase long-term bonds from banks. Those credits then sit on deposit at the Fed as excess reserves, where they don’t back new loans or circulate through the economy. For them to actually drive prices, banks have to use their increased bandwidth to lend enthusiastically.
Historically, QE has discouraged broad lending, and we doubt it behaves differently this time. When the Fed buys long-term bonds, it reduces long-term interest rates. (Bond prices and yields move inversely.) When this happens while short-term interest rates are pinned near zero, it flattens the yield curve. For banks, this creates a pickle, as government yields are the reference rates for their own funding costs (deposit rates) and revenue (the interest rates they charge on mortgage, consumer and commercial loans). When the gap between long and short rates shrinks, it reduces banks’ net interest margins—their potential profit on the next loan issued. This saps the incentive to lend to all but the most creditworthy borrowers, since banks—like any business—generally require a decent reward to make risk worthwhile. We think this is why, when QE ran during the last economic expansion, inflation (as measured by the Personal Consumption Expenditures price index) mostly stayed below the Fed’s target, 2% y/y.
As we write, the 10-year US Treasury rate is only 0.68%, just a whisker above 3-month yields. The number of loans outstanding has fallen since May, and the year-over-year loan growth rate is down from 11.5% in the week ending May 6 to 7.1% at July’s end, around where it was for most of 2016, which wasn’t an era of hot inflation. For loan growth to accelerate anew and spur fast inflation, the yield curve would likely have to widen significantly, which seems unlikely for at least as long as QE runs. Presently, the program has no official limit or end date.
So keep an eye on the Fed, but don’t let inflation chatter scare you away from stocks. Hot inflation is a commonly feared “second shoe to drop” in a young bull market and, usually, ends up as part of the proverbial wall of worry stocks climb.
Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.
Source: FactSet, as of 08/12/2020.
[ii] Source: Center for Financial Stability, as of 08/12/2020.
[iii] Source: FactSet, as of 08/12/2020.
[iv] Source: St. Louis Federal Reserve, as of 08/12/2020.
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