7 March 2021

We have all marvelled at the dramatic expansion of the US Federal Reserve’s balance sheet following both the Global Financial Crisis (GFC) and the Covid pandemic. And, the Chart illustrates quantitative easing (QE) policies have had a similar impact on the asset holdings of central banks worldwide (thanks to Yardeni Research for the Chart). For many years, many pundits have projected this monetary experiment would end in tears.

Current financial market volatility reflects heightened worries about the inflation outlook. Will the Cassandra’s finally have their day? (Excuse the literary reference, but I read Shakespeare’s “Troilus and Cressida” during lockdown!). Until recently, despite the unprecedent expansion in the Fed’s balance sheet, the closely-watched US M2 monetary aggregate has not grown by nearly as much. Inflation-hawks, however, now point to the recent 25% surge in US M2 money supply. Monetary aggregrates have also surged recently in Japan and the Eurozone.

In reaction to my last blog entitled “Will Inflation End the Party?” (available on my website), I have received many questions about the link between money supply growth and inflation. In addressing this key issue, I warn you I will rely on some rather technical (nerdy) economic tools. But, bear with me, it’s important! To be sure, both inflation and bond yields will rise further during the next 12-24 months. However, I believe price growth will remain modest enough to allow the US Federal Reserve (and other G4 central banks) to remain on the sidelines through 2022 at least.

The New Normal: Linking Money and Inflation

Monetarists’ belief that money supply leads directly to inflation relies on the following relationships:

1. Money Supply Growth (M) X Velocity = Inflation X Real GDP growth
2. Inflation = Money Supply Growth minus Real GDP growth

The second equation indicates that inflation occurs when money supply grows faster than real GDP (creating unneeded, excess money). The following Chart illustrates the close relationship between 1960-1990, and why this theory gathered so much support.

More recently, however, the link has weakened considerably. The following Chart illustrates that inflation has been consistently lower than implied by “excess” money supply (the gap between money growth and real GDP).

What’s gone wrong? In Equation 2 (above) the direct link between inflation and money growth assumes “monetary velocity” remains stable. Excusing the economic jargon, velocity is defined as the number of times each unit of money is used to generate national output. The monetarist theory worked well during the extended period during which velocity did remain stable. However, as the next Chart highlights, monetary velocity has collapsed in recent years, especially following the GFC and Covid crisis.

There are many possible reasons for the sharp decline in velocity. In the next section, we will discuss the role played by heightened risk aversion at US banks. From a macro perspective, lower inflationary expectations and interest rates have decreased the opportunity cost of holding cash (and other non-interest bearing assets). As disinflation (deflation) has been a global trend, one should expect velocity to decline world-wide. It has (next Chart)! With lower velocity, rapid money growth does not produce inflation.

Fed’s Balance Sheet: Not Just for Monetary Geeks!

In the past, only true monetary enthusiasts would pay any attention to the Federal Reserve’s balance sheet. Now, investors must scrutinise the weekly release. Quantitative easing (QE) has involved a huge expansion of the asset side of the Fed’s balance sheet via large-scale purchases of securities from banks (e.g. Treasury bonds, mortgage-backed securities, and others). The objective is that banks use the increased liquidity to make loans to support overall economic recovery. Unfortunately, however, rather than making new loans, risk-adverse banks have chosen simply to leave much of the money on deposit at the US central bank, e.g. creating an enormous stockpile of “excess” reserves (an off-setting liability on the Fed’s balance sheet) — following Chart.

In other words, the banks’ unwillingness to recycle the liquidity provided has led to a large increase in the US monetary base (of which banks’ excess reserves are the largest component) without the desired expansion in broader monetary aggregates, e.g. M2 or bank lending. Consequently, the so-called “money multiplier” (a measure of how many times liquidity is recycled through the economy) has collapsed — next Chart. Banks’ risk aversion, therefore, has contributed significantly to the earlier-observed decline in monetary velocity. As a result, the link between the monetary base (the most narrowly defined monetary aggregate) and nominal GDP — both inflation and real output — has been weakened even further.

Is Money Growth Getting Out of Control?

After expanding 5-6% annually in recent years, the closely-watched M2 aggregate surged in 2020, and is now growing 25%! Especially with financial markets already concerned about inflation, how worried should we be? To be sure, Chairman Powell reiterated recently the Fed intension to continue its $120-billion monthly asset purchases, which will expand banks’ reserves further for the foreseeable future (e.g. until unemployment is much lower). However, fortunately, there are some technical explanations for M2’s exceptional recent surge , which hopeful will run their course in coming months.

Without getting bogged down in detail, the Chart above illustrates the US Treasury has made a $1.5 trillion deposit at the central bank (green line). What seems to have happened is the Treasury issued debt for Covid relief, but has not spent it yet. As the Treasury deposit is a liability on the central bank’s balance sheet, the Fed purchased additional government bonds. Essentially, the Fed monetised the government’s additional debt. Don’t tell anyone, as it is not allowed! As a result, the Fed may have expanded temporarily its balance sheet more than planned; knowing the Treasury would soon spend the money (e.g. eliminate its deposit at the Fed).

Meanwhile, the Chart above illustrates a sharp increase in demand deposits (checking accounts) and liquid savings instruments (large components of the M2 aggregate). Again, this probably indicates that some individuals have not yet spent their Covid relief payments, which has been mirrored in a higher household savings rate. Similarly, I expect these funds will soon be spent (especially following the passage of the President Biden’s American Rescue Plan), which will correct part of the unanticipated (and non-inflationary) bulge in money supply.

Will Chairman Powell Do the “Twist” Again?

As bond yields rise and the yield curve steepens, speculation has grown that the Fed may repeat “Operation Twist”. In 2011, the Fed’s decision to extend the maturities of its fixed-income asset purchases led to a 125bp flattening of the yield curve (next Chart).

As welcome as a Twist 2 might be, I expect the Fed will not rush into action — as Chairman Powell recently announced. First of all, the Chart above illustrates that bond yields are much lower and the yield curve considerably flatter than in 2011. Secondly, a key objective of Operation Twist was to support the hard-hit housing market. The following Chart, however, indicates residential investment is healthier than during the GFC. Similarly, despite the economic hardship caused by the pandemic, commercial and industrial loans have not slumped as much as in the GFC. Indeed, corporations have taken advantage of low interest rates to significantly increase borrowing (leverage) by issuing new debt during the current recession.

Therefore, while Twist 2 is in the Fed’s tool box, I doubt it would be implemented unless 10-year yields approached 2.25% or market conditions became considerably more disorderly.

Strategic Considerations

• Inflation will rise in the USA, Europe, Japan, and China in 2021 and 2022. However, price increases will remain roughly in line with central bank targets by the end of next year.
• G4 central banks will remain on hold through the end of 2022, at least. In the United States, core inflation has averaged 1.8% during the past 10 years (2% below target cumulatively). If the US Federal Reserve actually implements an Average Inflation Target, the Fed conceiveably could keep interest rates low for even longer.
• Strong GDP growth and expansive fiscal plans (not money supply growth) will lead to US 10-year bond yields of 2.5% by year end 2022, and a steeper yield curve (the 10yr minus 2yr spread will approach 200bp.
• European inflation and bond yields will rise less (market will outperform).
• European and Asian equities will outperform the US market this year.
• Highly expansive US monetary and fiscal policies should lead to larger twin deficits and a weaker US dollar. However, US GDP growth could surprise relative to the rest of the world in 2021 (I will review my forecast after the Biden Administration’s American Rescue Plan is confirmed). Stronger-than-expected economic growth may offset US dollar risks, at least in the near term.