Intelligence

Money and Inflation

Milton Ezrati

Chief Economist

The Federal Reserve (Fed) made another move to raise interest rates last month and promised three more such moves in this new year. In a technical sense, one could say that they have tightened monetary policy, but this most recent move and those to come would be better described as an effort to make policy less easy. Confident that the economy will continue to grow, if not particularly rapidly, the Fed is continuing with its plan to normalize policy from the extreme ease it had adopted to cope with the 2008-09 financial crisis and the lingering economic effects in the intervening years. Recent data on inflation and money growth have given the Fed added reason to pursue this normalization policy.

The investment community has almost stopped looking at the inflation figures. Inflation has remained so quiescent for so long that many investors have forgotten even how to cope with it. Recent data hardly suggest matters are urgent, but they have thrown up a few warning flags, enough surely to have captured the Fed’s notice. Some strategists, to be sure, have dismissed this picture, denying flatly that inflation could become a problem. They may be correct, but it would be unwise for investors or the Fed to dismiss the prospect out of hand.

Certainly, consumer and producer prices have called attention to themselves. Back in 2015, and even earlier this year, these inflationary measures indicated negligible pressure. In some months, general prices levels actually fell. For the last six months, however, things have changed. Consumer prices have accelerated, growing by an annual rate of 2.7 percent. If not an especially frightening pace, it is nonetheless a sharp contrast to the 0.7 percent inflation rate averaged over the course of 2015 or the 0.9 percent rate averaged during the 12 months to this past March. Producer prices tell much the same story. These have risen at a 1.7 percent annual rate during the last six months, hardly fast but far different from the small outright decline recorded for all of 2015 or for the 12 months ending this past March.

Such comparisons would be easy to dismiss had they reflected shifts in the prices of food or fuel. These have a reputation for volatility and tend to correct over time. But this recent acceleration is more general. In fact, the volatile food and fuel elements have run counter to it. Consumer energy and food prices during the past twelve months have risen at a slower pace than prices generally. It is they that have fueled the recent inflationary signs. Similar comparisons hold when making the calculations from producer price statistics.

Signaling that these inflation accelerations may deserve special attention is the recent behavior of the money supply. Fewer links in economic and financial life are better established than the one between inflation and the growth of the money supply. The relationship is not so rigid that it explains year-to-year swings, much less month-to-month movements, but over time, in any economy, excessive money growth leads to inflationary pressure — hence the old saw: too much money chasing too few goods. Money growth had remained contained during much of this recovery since 2009, remarkably slow in fact given the amount of liquidity the Federal Reserve (Fed) has poured into financial markets. During the last six months of 2015, for instance, the narrow M1 measure of money, which includes currency in circulation and checkable deposits at financial institutions, grew at less than a 4.3 percent annual rate, not much different from the nominal economy’s rate of expansion. But that picture has changed radically during those last six months, during which this M1 calculation of money has jumped at an 8.1 percent annual pace.

Most worrisome for the longer term is how the Fed’s past policies have laid the groundwork for a continuing, inflation-fostering money explosion. Policies of zero interest rates and quantitative easing over years have created an enormous amount of liquidity in the financial system. As an indicator of how far matters have gone, the Fed’s balance sheet has swollen from a touch over $900 billion before the financial crisis of 2008-09 to about $4.5 trillion at present. The flood of liquidity has expanded reserve holdings at financial institutions from a relatively narrow $3.0 billion above legal requirements to some $2.5 trillion recently. Because this liquidity is the basic stuff of money creation, the financial system today finds itself with a huge potential for money growth that could easily create considerable inflationary pressure. The Fed could disarm the threat by removing the excess liquidity but is doubtless loathe to mount what clearly would be a massive operation for fear of, among other things, an immediate negative impact on the real economy.

Matters at the moment are far from acute. Indeed, the recent growth of money may well indicate that the basic liquidity built up over the years has at last begun to flow into the economy. The pace of real economic growth might as a consequence pick up from the disappointing pace averaged so far in this recovery. But beneath this pleasant prospect lies a dangerous inflationary potential that investors and strategists dare not ignore. They may have time yet before they have to adjust their portfolios to cope with it. But it is time for them to note inflation’s adverse potential impact, especially on bond prices, and consider how they would change strategy. That need suggests strongly that the Fed will continue its recent policy course, that it may bring up such matters more frequently in its press releases and other commentary, and that discussion of money growth as well as inflation will appear increasingly on investment agendas and in media outlets.

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