Does the recent growth in money supply (still) guarantee years of inflation?  Traditional thought on this old theory may soon be tested.

 

 

Every Friday, during the inflation jump in the 1970s, the eyes of financial analysts and economists were focused on something called M2, which represents the broadest measure of money supply growth.  Just as in the attached image of the carved image of a trader, this information was generated by a Dow Jones terminal that constantly churned out a paper ribbon, rife with the top financial news stories of the day. 

 

Milton Friedman, the 1976-Nobel-Prize recipient for Economic Science, famously stated that “inflation is always and everywhere a monetary [i.e., M2] phenomenon.”  However, people today are questioning the causal relationship between M2 and the rate of inflation.  After all, inflation as defined by CPI (Consumer Price Index) in both Canada and the United States, which between 1979 and 1981 was running above an annual rate of 10%, remains subdued today at below 2%.  And yet, as our chief economist Avery Shenfeld points out, “In the US case, data back to the [Theodore] Roosevelt administration [… 1901-1909] shows no equivalent [in growth in M2].  In Canada, the leap takes us back to a pace not seen since the high-inflation world of the 1970s and 80s” (Economic Insights February 2).  

Chart 1 shows that the growth in M2 has rocketed upward, the result of the coordinated efforts of central bankers and governments to flood the system with money in order to ward off the economic ill-effects brought about by the pandemic.

 

Shenfeld goes on to suggest that the combined monetary and fiscal policies have yet to cause an increase in inflation since most of the funds issued remain on deposit in bank accounts and investments.  We won’t see a CPI increase until, and if, we get “the rounds of borrowing, and subsequent spending, that is typically associated with a massive expansion in the monetary base […]” (Economic Insights February 2). 

 

Randall Forsyth, in a more simplistic view, takes his cue from the bond market: “Bonds Send Message—Inflation Is Coming” (Barron’s February 8).  Far more important than all the noise around the hugely speculative rise and fall of Gamestop’s stock just recently was “the more fundamentally important financial development […] in the bond market. ”  Forsyth maintains that the upwardly sloping yield curve, with longer term bond interest rates growing more rapidly than short-term bond rates, “is a classic indication that the bond market is anticipating stronger economic growth and higher inflation.” 

 

He maintains that Biden’s fiscal spending package of $1.9US trillion simply adds to those inflation expectations.   The 10-year US treasury bond yield has jumped from just under 0.60% in early August to 1.16% during the week of February 7th.  While still near a historical low, the increase can be characterized as substantial (see Chart 2).

On Tuesday, February 9, The Wall Street Journal cited a Citigroup Inc. report that concluded a rise on the 30-year bond yield to as much as 2.44% (from 1.95% presently) was indeed possible.   Meanwhile, central bankers (the Federal Reserve) in the US remain steadfast in their commitment to keeping the discount rate (the rate charged by the Fed to banks for overnight collateralized loans to member banks) to a paltry 0.25%. 

 

It may seem like a long time out, but within 3 to 5 years, we are likely to have the evidence, i.e., higher interest rates, supporting the Milton Friedman assertion, or something to the contrary.  We are believers in fixed-reset preferred shares and short-term bond maturities, a stance consistent with Friedman’s teachings.  Meanwhile, we have not even explored the issue of the US dollar as the world’s currency reserve, and what would happen if that position was ever eroded.