Inflationary Inflection Point Or Temporary Blip?

During the last three months inflation has become a much debated topic. This article, which was published in March, may still add something to the increasingly heated debate: 

 

In this article I look at the longer-term prospects for inflation in the US. The lockdown decline and subsequent recovery in GDP growth, together with the concomitant fall and rise in prices is already evident. Meanwhile, the forward-looking stock market continues to travel hopefully, anticipating the end of restrictions and a return to the new normal. The bond market, by contrast, may be starting to express fears that the largest peacetime stimulus in history might have longer-term inflationary consequences. 

Since making all-time low yields in August 2020, US 10yr Treasury Bond (SPTL) yields have risen steadily, but, as the chart below reveals, only back to the depressed levels of H2, 2019 and mid-2016. Is this a post-lockdown correction or an inflection point, or is it too soon to say?

Source: Trading Economics

The high growth stocks which dominate the Nasdaq 100 (NDX) index briefly took fright, in some cases retreating by more than 30%, but the broader index rapidly regained composure. As the next chart (March 22) shows it is presently just 5.2% below its all-time high. Looked at over the past decade, one could be forgiven for thinking the recent retracement is simply some overdue profit-taking in an otherwise unblemished multi-year bull-market: –

Source: Yahoo Finance

The broader-based S&P 500 Index (SPX) remains staunchly within striking distance of its all-time high made on March 17. So, why is the financial press awash with talk of tightening despite assurances from Federal Reserve (Fed) Chairman Jerome Powell to the contrary? The main reason is a belief, especially among the ranks of the so-called bond vigilantes, that the combined monetary and fiscal stimulus which mitigated the immediate economic impact of the pandemic will, as the global economy rebounds, lead to structurally higher prices for goods and services.

‘Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.’

Milton Friedman

When Friedman wrote about the variable lags between increases in the monetary base and inflation, it was an era of relatively stable velocity of monetary circulation. By contrast, over the past two decades that velocity has fallen steadily: –

Source: Federal Reserve Bank of St. Louis

Bond yields may have risen but there is scant evidence of a rebound in the velocity of monetary circulation. The end of the lockdowns may see velocity return to its trend, but the trend has yet to turn; what factors could make this the inflation inflection point?

We need look no further than AIER’s Gregg van Kipnis who, on March 17, published a fascinating analysis entitled Inflation Outlook: Likely Worse Than Expected. The author examines the reasons behind the absence of inflation, despite the excessively accommodative monetary policy of the last decade. He argues that a key factor was the introduction of IOER – interest on excess reserves held at the Fed – which effectively sterilized a large proportion of the newly created monetary balances. For a detailed explanation of the Fed policies – Why did the Federal Reserve start paying interest on reserve balances held on deposit at the Fed? Does the Fed pay interest on required reserves, excess reserves, or both? What interest rate does the Fed pay? from FRBSF is a good starting point.

Van Kipnis argues that the declining velocity of circulation in the face of rising money supply is also a function of the lack of opportunity in the real economy. This anemic investment environment is also reflected in the flatness of the US yield curve. In the chart below, van Kipnis shows the closeness of the relationship between the velocity of circulation and falling bond yields: –

Source: Federal Reserve Bank of St. Louis

The FOMC statement from March 17th gave upward revisions of their GDP and inflation (PCE) forecasts for Q4 – to 6.5% and 2.2% respectively, but reiterated that monetary policy remains unchanged: – 

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