Over the last 10 years, the federal reserve has pumped over 10 trillion dollars into our economic system as measured by M2 money supply.
M2 money supply is simply the measure of all household dollars held in deposits, CDs, money markets, and liquid funds. In June of 2011, the US supply was a little over $9.1 trillion, and as of March of 2022, we are approaching $20 trillion.
M2 Money Supply
Naturally, with all of this money floating around in disposable accounts, there is a real fear among investors and business owners that—as we have already seen in lumber, steel, and housing prices—high inflation may be looming. This article is not an attempt to predict where and when inflation will occur but rather to explain how inflation, if it does occur, may present itself in the future. As of today, inflation has not been a major factor, but we are seeing some activity.
The Consumer Price Index (CPI) is universally used to measure the price of household goods and services. This includes food and beverages, rent on housing, clothing, transportation, medical care, recreational activities, and education to name a few. It currently sits comfortably at 4.16% year-over-year from April of 2020, an increase from 2.62% last month and above the long-term average of 3.21%.
Consumer Price Index YoY
In economics, there are two actions that cause reactions that inevitably lead to price increases. They are “demand pull” and “cost push.” Demand pull occurs when there are more dollars in the system for available goods, demand is high, and prices are being pulled upward. Cost push, on the other hand, occurs when the cost to produce a good or service is increased and passed onto the consumer.
According to recent statistics, the price of goods and services is trending upward, so let us look at five reasons why this might be happening:
1. GROWING ECONOMY (DEMAND PULL)
The price of consumer goods and services will increase as the economy expands organically. When unemployment rates drop and wages increase, people naturally find themselves with more disposable income. That disposable income is used on everyday goods like food, transportation, and discretionary items. This increases demand which in turn forces businesses to raise prices gradually to counter. It also encourages businesses to increase production to meet demand, thereby creating more jobs and more money circulating into the system. This is the healthiest way an economy grows: inflation in its simplest form free from external manipulation of supply and demand. Remember, a good dose of inflation is a positive thing and not something to be feared. Historically, 2-3% growth is very manageable progress.
2. GOVERNMENT REGULATIONS (COST PUSH)
Our economy is a complicated system and, over time, different taxes and tariffs are imposed on corporations that produce or import goods and services. Governments will do this to increase their tax revenue, and the biggest needle movers are businesses. In fact, government revenue and government spending continue to operate on a margin with government revenue decreasing from 20% of GDP in 2013 down to 17%, while government spending has increased dramatically from 22% to 37% of GDP during the same time period. Although government spending can often provide stimulus packages and social welfare programs to assist those in need, this overspending will have a negative impact on the economy that will be experienced by all U.S. citizens.
The impact of regulatory sanctions is highlighted in the banking system. The government can tighten credit requirements on banks to shrink loan supply or loosen them to steer money to businesses who in turn invest in equipment or hire more employees.
3. EXPANSION OF MONEY SUPPLY (DEMAND PULL)
Money supply is the most publicized driver of inflation for two reasons: 1) it is self-explanatory and has a direct correlation to supply and demand, and 2) with the recent pandemic and the government’s goal to sustain economic activity, stimulus packages, PPP loans, and tax credits have injected trillions of dollars into our system resulting in an increased awareness of money supply. Remember, when money is infused into the economic system, the theory is that it can quickly lead to more disposable income available, eventually driving up demand. As money supply skyrockets ($2.2 trillion at the start of March 2020, followed by another $3 trillion in Q1 of 2021) there is real concern from institutional investors like Warren Buffett (CEO of Berkshire Hathaway) and Jeff Gundlach (CEO of Double Line Capital) who focus on economic fundamentals.
4. NATIONAL DEBT MANAGEMENT (COST PUSH AND DEMAND PULL)
It is no secret that the US debt management program has been loose at best. Our great nation has the second highest GDP in the world but continues to operate in negative cash flow year after year. When this happens, the government has two options to counter this trend. The first is to increase corporate taxation, which is already starting to happen. In order to survive, businesses will pass this cost down to the consumer. The second option is to print more money, which as we mentioned earlier can lead to increased demand. The nation’s debt level was $26.95 trillion as of the end of 2020. The current debt level is $28+ trillion and counting.
5. GLOBAL EXCHANGE RATES (COST PUSH)
One of the reasons Bitcoin and digital currency continue to be fictional concepts is because they lack stable value. It is difficult to use a currency to purchase goods and services when the value of what was paid changes drastically overnight. Imagine paying your employees what you thought was a $15 per hour wage and the next day it jumped to $35 per hour. Until the federal reserve can understand how to better value the digital currency space, it will remain a pipedream and a speculative hobby for recreational investors. As it pertains to inflation, when the value of the dollar dips as compared to the rest of the world, our businesses have to pay more for materials, supplies, and outsourced services. When these costs start to build up, businesses will increase their own prices domestically to make up the difference.
As the pandemic loosens its grip on our economy and we begin to look forward, we must keep in mind that a good percentage of the approved stimulus dollars will be rolled out gradually. It is difficult to predict how the dollars already injected into our system will be deployed by consumers, but you can track both indicators using M2 money supply and the velocity of money. As of this writing, velocity has been tame and most of the dollars are being saved not spent. See our Senior Trust Advisor Mike Tallman’s recent blog and our Portfolio Manager Anthony Smith’s White Paper for a deeper look.
However, regardless of short-term predictions, no one will disagree that there is an excess storage of cash sitting in household checking, savings, and Money Market accounts yet to be deployed, and that in itself is scary. The federal reserve chairman, Jerome Powell, and Secretary Janet Yellen believe that any effects of inflation will be transitory and short-term in nature as the global pandemic slowly comes to an end, allowing for the gradual reopening of all sectors and hopefully a stabilizing of prices in 2023 and beyond.
Managing Director, HFG Trust