July Newsletter: Is Inflation Dead?

Posted by Alex Frey (@alexhfrey )

We've repeated many times at IvyVest that there is no such thing as a long-term risk-free investment. A big reason for that is that cash can dramatically lose its purchasing power over time. Sometimes this happens gradually, and sometimes it happens quickly in a spurt. This is, of course, inflation, and it has been with us since the beginning of government-created money.

But in recent times it has seemed that we have tamed the inflationary beast. This makes us ask: Is inflation dead?

It certainly isn’t dead everywhere. Argentina is expecting about 50% inflation this year; Turkey is having about 20% inflation, and Venezuela is having hyperinflation that could reach a million percent this year, meaning citizens have essentially lost all wealth that they did not put in the form of a foreign currency or other inflation-hedged asset like gold.

However, in the developed world, inflation has been very low for a long time. Figures 1 to 3 show the annual change in the consumer price index (CPI) (or its equivalent) for the U.S., the Euro Area, and Japan. In all three cases, inflation has been quite low and less than the target, about 2%, that the central banks are aiming for. China also has a low inflation rate, as shown in figure 4.

Although inflation is low now, the U.S., Japan, and China have all had significant bouts of inflation at one time or another in the last 40 years. The Euro area came into existence with the creation of the Euro in 1999, so the Euro data doesn’t go back very far, and it has escaped significant inflation so far. We might comment that the Federal Reserve seems to prefer the personal consumption expenditures index (PCE) over the CPI when discussing inflation, but the major trends are the same for both indices.

FRED-CPI.png Figure 1: Annual growth rate of the CPI for the United States. Data is from the Federal Reserve Economic Data (FRED), St. Louis Federal Reserve Bank.

FRED-CPI-Euro Area.png Figure 2: Annual growth rate of the CPI for the Euro Area. Data is from the Federal Reserve Economic Data (FRED), St. Louis Federal Reserve Bank.

FRED-CPI-Japan.png Figure 3: Annual growth rate of the CPI for Japan. Data is from the Federal Reserve Economic Data (FRED), St. Louis Federal Reserve Bank.

FRED-CPI-China.png Figure 4: Annual growth rate of the CPI for China. Data is from the Federal Reserve Economic Data (FRED), St. Louis Federal Reserve Bank.

So why is inflation so low now, and are we likely to see more bouts of high inflation in the future? Milton Friedman, a Nobel Prize winning economist, is famous for saying that “inflation is always and everywhere a monetary phenomenon”. He meant that the quantity of money and its velocity (the rate that it is exchanged) determine the degree of inflation. If the money supply increases faster than the supply of goods and services, then prices are expected to rise. This thought is expressed by the equation

MV = PQ,

where M is the money supply, V is its velocity (the number of times it is exchanged in a year), P is the price level, and Q is the total supply of goods and services (usually taken to be the gross domestic product, GDP). To some extent, this equation is simply an obvious identity, because once the price level and Q (taken to be GDP) are determined, V can always be adjusted to make the equation work. Nevertheless, it is instructive to look at how the money supply and money velocity have been changing over time.

Before we go on, a very brief primer on money and money supply might be helpful. First, we need to define what money is. It is much more than just currency and coin. Economists have several different definitions of the money supply. We will talk about M1, M2, and MZM. M1 is the currency in circulation (including coins), checking accounts, and other demand accounts where the money can be withdrawn at any time without notice. M2 includes M1, but it adds in short-term time deposits in banks and money market deposit accounts for individuals. MZM stands for money zero maturity, and as the name implies, it includes any financial instrument that can be redeemed immediately at par value. So, it includes everything in M1 plus all money market funds, but it excludes all time deposits.

Money can be created in two ways. Banks create money when they lend. The borrower spends the money, and it ends up deposited in some other bank, which can lend a portion of it again. Thus, there is a money multiplier when banks lend. The Federal Reserve System (Fed) controls this process by requiring banks to hold reserves and by fixing the interest rate that banks charge one another for overnight deposits. The Fed can also directly create money by buying bonds or other assets. When they do this, they are injecting new money into the system, which may be multiplied when banks lend it out. The Fed did this in their “quantitative easing” (QE) program in the years after the Great Recession. Many people expected this to cause inflation, but it didn’t. Going back to the equation above, we can note that an increase in money supply can be accommodated by a decrease in velocity V, or by an increase in the price level P (inflation), or by an increase in GDP (Q). The intent of the Fed when it conducted QE was to increase total economic activity (GDP). We can debate to what extent QE did this, but it didn’t cause inflation and GDP did increase, albeit more slowly than many people would have liked.

So, what has been happening to the money supply over time? Figure 5 shows how the various measures that were defined above have varied over time. Clearly, the year to year change can be very different depending on what definition is being used. However, by all definitions the growth of the money supply in the years immediately after the Great Recession was high. This was when the Federal Reserve was buying bonds as part of their quantitative easing (QE)program. However, the data also indicate that the correlation between money supply and inflation is very poor if it is evaluated on a year to year basis. Figure 6 shows how inflation (as represented by the CPI) compares to changes in M2. The correlation is poor, and comparisons with the other money supply definitions aren’t any better.

money_chart.png Figure 5: The annual growth rate of MZM, M1, and M2. Data is from FRED.

cpi_chart.png Figure 6: Annual growth of CPI compared to annual growth of M2. Data is from FRED.

The lack of short-term correlation between money supply and inflation is explained, to some extent, by the variation in the velocity of money. Figure 7 shows how the velocity associated with each of the money stock definitions has varied with time. The velocity associated with M1 is larger than the velocity associated with M2 and MZM simply because M1 is smaller. However, in all cases, the velocity has been decreasing since the Great Recession. The reduction in velocity is a major reason that we have not had inflation, so why is velocity falling? In part, this is because the yield curve has been flattening (long term rates have dropped more than short-term rates), so some people are content to leave their money in short term accounts, which are included in the money supply, rather than putting it in longer-term, higher yield accounts. Even though the money is in demand accounts, it may not turn over very often and contributes to a low money velocity. Another factor is that banks have been holding excess reserves rather than lending to the maximum extent, as they normally do. Figure 8 shows the historical trend of excess bank reserves. Only recently have banks had significant excess reserves. If banks started to lend more, this would tend to increase both the velocity of money and the money supply (because bank lending creates money). There is also another factor that may be influencing the velocity of money. In recent years, an increasing portion of national income has been going to the wealthiest people. They are far more likely to save it than lower income people would be. They may invest some of it back into the economy, but it’s quite possible that they are letting some of it sit in money market funds or bank accounts. This would lower the velocity of money. If more money were going to lower income people, it would be spent more rapidly, and this would increase the velocity of money and thereby have a bigger effect on inflation.

money_velocity_chart.png Figure 7: The velocity associated with different money supply definitions. Data is from FRED.

FRED-excess reserves.png Figure 8: Excess reserves in the banking system as a function of time. Data is from FRED.

Of course, there are other factors that affect inflation besides purely monetary ones. Inflationary expectations can have an effect. If the public expects inflation, people will be more likely to accept price increases and merchants will more likely get away with price increases. International competition can also have a big effect. If cheaper products are available abroad, merchants will be reluctant to raise prices and workers will be less likely to press for higher wages, and this will hold down inflation. The fact that such effects exist does not invalidate the equation above, but it may drive the Fed to take actions that it would rather not take. So for instance, if inflation expectations are driving prices up, the Fed may have to accommodate this by increasing the money supply faster than they would like. If they don’t do this, increasing prices could push the economy into recession (decrease of Q).

While the correlation between money supply and inflation doesn’t seem very good on a year to year basis, it is better when longer term averages are considered. A paper from the Cleveland Federal Reserve Bank (reference 1) looked at this issue. It compared inflation (expressed as by the GDP deflator, which is closely related to the CPI), to the “growth of the excess money supply”. This is the growth of the money supply minus the growth of GDP. Going back to the equation above, if M and Q increase at the same percentage rate, the price level can remain unchanged, so it is excess growth in the money supply that might cause inflation. The Fed authors looked at the period from 1930 to 2012, and their results are shown in Figure 9. When they compared inflation and excess money supply on a year to year basis, there was no correlation, but when they made the comparison using five-year averages, there was a strong correlation. Their results are shown in Figure 9.

gdp_deflator.png Figure 9: Inflation (GDP deflator) plotted against the percent change in excess money (growth in money supply minus growth in GDP). On top, the comparison is year to year. On bottom, the comparison is on five-year averages.

So, let’s summarize. It seems that there is a correlation between excess growth of the money supply and inflation. In recent years, the Fed injected significant money into the system, but its effect was absorbed by a decrease in the velocity of money and an increase in GDP, with the net result that there was very little inflation. What is likely to happen in the future? The Fed has the tools to control the money supply, but its ability to use them may be constrained. The U.S. budget deficit is large and increasing. Without intervention from the Fed, the government must borrow the money by selling bonds, and this can drive up interest rates and push private borrowers out of the market. Eventually, this could shut down economic growth. Alternatively, the Fed can accommodate the deficits by buying government bonds. This solves the government’s deficit problem, but it injects money into the system. If the economy is already operating close to full employment, GDP may not grow fast enough to accommodate the increased money supply, and it seems unlikely that one can count on further drops in the money velocity to accommodate the increase in money supply. In fact, new tax policies or other policies that direct money away from the wealthiest people and towards lower income people could cause an increase in money velocity. It seems to us that such policies are quite possible after the coming election.

A further worry is that the political will to avoid government deficits seems to have evaporated in the U.S. The Republicans seem to be assuming that a growing economy will pay for the current level of spending without tax increases, but few economists agree, and forecasts by the Congressional Budget Office show the deficit continuing to grow faster than GDP. Many democrats are now talking about Modern Monetary Theory, which deemphasizes the importance of deficits. We won’t go into Modern Monetary Theory here, but it might be a good topic for a future newsletter. What worries us is that both parties in the U.S. seem to be coming up with reasons to ignore the growing deficit. This is very convenient politically, but we doubt that it will end well. Furthermore, we seem to be seeing some of the same tendencies in other countries.

This is a complicated world, and we hesitate to make predictions. But, we think investors are making a mistake if they assume that inflation is dead.


Owen Humpage and Margaret Jacobson, “Prices from a Monetary Perspective”, Cleveland Federal Reserve Bank, 2013

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By Alex Frey