Inflation in the USA: A delicate balance (P*T = M*V)
Author: Jeffrey Cohen, President, Chicago Quantum, Updates May 19, 2021 and August 5, 2021
I attended the University of Chicago in the late 1980s in the economics department. We were taught inflation by a Nobel Prize winner in economics, Robert Lucas Jr., who spoke about Rational Expectations (often). He was a great professor who taught us a simple definition of inflation.
Systemic inflation is a monetary issue. Individual prices rise and fall due to supply and demand, but it takes a monetary policy change to impact large groups of prices at the same time.
Inflation is the growth rate of GNP — growth rate of money supply, or d(GNP)/d(M). Seemed easy, and in hindsight I used to check the WSJ and it would tie out historically to within 0.1% per year. How to keep inflation to zero? A monetary policy specialist needs to accurately predict the growth in GNP for next year and create that much liquidity (or money supply) in the market.
There is a new definition of price levels (not inflation) that is a little more nuanced. These are not growth rates, but can be considered that way.
Price Level (P) * Transaction Volume (T) = Money Supply (M) * Velocity of Money (V); which can also be written: P * T = M * V
Prices = (M * V)/T
Money Supply = (P * T) / V
Velocity of Money = (P * T) / M
We started by looking at inflation in certain areas, like wages.
Wages are set by paying people what their labor produces, less profit. As labor value is subjective, growth rates help us normalize the average changes across our society. Wages (unit cost of labor): up 1.6% in the past year (Q1/20 — Q1 21), while productivity is up 4.1%. So, labor costs actually fell 2.5% this past year. No inflation in wages over the year. How about in Q4/2020? Hourly compensation up 5.1%, while non farm productivity up 5.4%. Still no wage inflation. (source: BLS.gov).
Prices for commodities and ‘stuff.’ How about energy? Yes, prices are up 25%, but heard it was due to elastic demand (daily decision to drive/spend) and inelastic supply (takes 6 months to drill and ’TIL a well). Pipelines take a year to construct after years of approval processing. We will see gasoline prices rise at the pump due to a hacker attack on Colonial Pipelines, which takes consumer money away from other purchases (like food) in the short run.
Housing? Yes, prices are up but I heard it was due to low inventory. Looks like over the past month energy prices are up, and about half the commodities. Half the commodities means there are specific factors at play, constraints in supply chains or production areas. Food is up 2.4% this past year (see BLS/CPI chart).
My conclusion is that inflation (rear-mirror view) has not been significant.
Demand looks like it is coming back, assuming the recent improvements in the US and certain other nations around COVID (e.g., Israel, UKI) continue and spread globally. Anecdotally, things in Chicagoland are approaching ‘back to normal’ status per what I hear about and see personally. Workers are being called back to their offices too.
Shipping demand is rising. Maersk stated recently that imports into North America from Asia rose 40% in the first 3 months of 2021. It lifted its forecast for global container demand growth to 5% to 7%, up from a 1.8% decline in 2020. Maersk is buying more containers, but not more ships. Shipping and supply chain congestion example, along with the EverGreen Suez issue.
There is greater awareness and discussion of inflation. Inflation is a fast running topic today in Twitter (I opened a feed, and it scrolls new messages every minute), and I read that “Mentions of inflation on first quarter corporate earnings calls have exploded 800% year-over-year, according to new research from Bank of America Securities.”
I also read that the markets are falling because of inflation concerns. So, with inflation top of mind, let’s get to the bottom of it here, now, in this article.
Getting back to monetary policy and the quantitative view of inflation…
GNP is growing ~7%, and with our US economy at about $22T, this creates a latent demand for $1.5T in new liquidity (or money) annually.
Our US Federal Reserve Board is buying $120B in Treasuries and mortgage backed securities (MBS) and maybe some commercial paper monthly. This puts $1.4T of liquidity (money) into the economy each year.
Case closed…or is it? What about the stimulus payments and spending of a few trillion dollars this past year? How about a government deficit causing us to reduce liquidity (by selling bonds)? How is our money supply doing?
The chart below is a huge eye opener. M1 is the most direct form of money that is immediately spendable, or on demand. M2 includes M1 plus includes money that might take longer to spend, like deposits in a CD or money market fund. That is up from $15.3T to $20.0T, or about 1/3 in 16 months. This number is increasing $200B to $400B each month most recently.
In summary, M2 (money supply) is up ~1/3, or 33%, in a little more than a year. Our GNP is up ~ 9% in the same 16 months. We are creating the conditions for inflation, about 24% over 16 months, or 18% one time.
The Federal reserve knows these numbers, so why would they inject 18% more money into the system? The answer is a decline in the velocity of money.
Here is a chart from the Federal Reserve on the velocity of money (M2)? Looking back 50 years, it has reached a peak over 2.0. Before 2010, money flowed with a velocity of 1.7 or above.
Once the pandemic hit, it crashed from 1.4x to 1.10 (50 year low), and it is now at 1.123. Our velocity of money is down about 25%, or 1/4.
What I take away from this chart is that America (both corporate and individual) is deleveraging. America is ‘hunkering down’ and staying safe, and not spending, borrowing, lending, nor investing in the real economy the way it used to. Money flows have significantly slowed during the pandemic. Money flows to assets like the stock market, or real estate, which have both risen due to increased investment and money flow.
The Federal Reserve has been playing a balancing act, and up to now has gotten it right. When we look at our price level formula: P * T = M * V, we see that to keep prices flat, or at least un-impacted by monetary policy, then M * V have to stay constant. As we see below, we are in alignment and inflation is not caused by monetary policy, but by transitory issues and post-pandemic supply shocks.
Money Stock (M2): +24% (up 33%, normalized for 9% GNP growth)
V: -25% (down to lowest levels in 50 years, from 1.45 to 1.123)
So, why is everyone worried about inflation? If we assume, like Professor Robert Lucas Jr. taught me that investors have Rational Expectations and are not tricked or fooled by statistics, then something is changing.
Here is my conclusion and hypothesis for what is happening:
- Up until now, the Federal Reserve and our Federal Government has played a delicate balance, replacing liquidity that was destroyed by main street inactivity through open market transactions and direct payments to people. It had to…a 25% reduction in velocity could have resulted in not enough money to go around…and price deflation. (imagine your asset value drops, but your loan stays the same)
- The velocity of money may rebound due to post-pandemic demand increases…and it may do so quickly. If so, the Money Supply will have to be decreased or we will see massive increases in systematic inflation. Fast money will chase prices ‘to the moon.’
- Supply chains are stretched thin. Certain commodity prices are rising (especially energy where supply is inelastic or slow to change). Labor markets are tight as people have gotten used to working from home, or lost skill-sets, or lost their place in the working world. Wages have not really risen at all (adjusting for productivity) and there is talk of another stimulus.
- Few believe that the US GDP will grow faster than 7% to absorb the increase in liquidity.
However, the US equity markets are scared today. If the US economy grows but the velocity of money stays the same, then the Fed can continue with easy money policies until they reach their goal of full employment and 2% annual inflation. Status quo.
If the US economy grows too quickly, and main street increases borrowing and lending, investing and spending, then the velocity of money rises. A 10% increase in the velocity of money (from 1.123 to 1.235), all things being equal, would require removing ~$2T in M2 (liquidity) from the system.
That is a very scary thought, as it looks like a tapering or ending of Fed bond purchases, possibly selling bonds it already owns, increases in reserve requirements on banks, and possibly an increase in borrowing rates on banks and corporations that borrow directly from the Fed.
I hope you found this article helpful and timely.
May 19, 2021 update: Since this article the markets have moved their focus elsewhere. Prices for assets have fallen, and the VIX (or fear gauge of stock markets) has increased. Prices for supposed ‘substitution assets’ for US Dollars are down significantly (crypto-currencies). Here are two charts to prove the point from Finviz:
In truth, I cannot find any new US Government official data on money supply or prices. Here are existing data-points:
April CPI up 0.8% (MtM) and 4.2% (YtY). Source:
Velocity of M2 Money Stock: 1.123 as of April 29, 2021. Source:
Total Fed Reserve Assets: $7,831 Trillion as of May 12, 2021. Source:
M2 Money Supply: $19.9 Trillion as of March 1, 2021. Source:
Treasury Inflation Protected Securities yields: All negative yields. You pay for insurance against inflation. Source:
August 5, 2021 update: The Fed Strikes Back: The first thing we notice is that the M2 money stock (liquid cash and demand deposits, along with small and short time deposits) is flat for a month. As discussed in my recent video, this happens infrequently and is a special occurrence.
The second thing to notice is that FED assets declined this week, and for the month assets increased by $120B (the quantitative easing (QE) program). In other words, the FED stuck to the script and purchased their securities, but was net neutral for their balance sheet outside of QE. This is also unusual, and reflects FED action to limit growth in money and reserves in the system.
We found this page in a detailed report by the FED that shows how increasing reserves ultimately increases cash deposits in the US economy. Without loan growth (which is still weak), the FED has another tool, growth in reserves.
Finally, we see that large US banks are ‘parking’ a significant amount of money with the FED each night recently. The amount reached $1T this past week, and is still at $909B. To me, this means that the large banks do not have alternative ways to invest, loan or otherwise make productive use of their deposits and are parking them with the FED for around 5 or 6 basis points, and recently for 12 basis points.
We also see a reduction of yields across the board from the 5-year to the 30-year US Treasury securities. With the exception of a strange period earlier in July (July 19 & 20), rates have been falling for the past month. There is a flight to quality, or safety, to the largest, and most liquid risk-free security.
In conclusion, the FED is taking aggressive action within its constraints to tighten monetary policy. It has slowed the growth of M2 money supply, is tightening the growth of its assets (debt securities it holds). In terms of a market response, we see money being parked at the FED overnight for nominal (~0%) yields, and a continued reduction in US Treasury note and bond yields.
These data points add up to a conclusion for us. We believe the US equity market is facing a flight to quality and safety to longer-term notes and bonds. We believe the market will be forced to react to a reduction in money supply. This is bearish for the passive market indices (like the Wilshire 5000, the S&P 500, NASDAQ Composite and Russell 2000), although individual securities will still move up and down.
For more information about our thoughts day-to-day, you can follow us on Twitter, here.
Jeffrey Cohen, President of US Advanced Computing Infrastructure Inc.