Why investors should not be worried about the expansion of the money supply causing inflation in four easy charts.

[curiousspring]

Introduction: There has been a lot of discussion as to the increase in money supply and inflation. Most seem to think that an increase in M2 inevitably leads to inflation in prices of goods and services. This couldn't be further from the truth. There was previously a strong correlation between the two up until 1990. From then on, the correlation has reversed and is negative. There is now a much stronger relationship between increases in the money supply and decreases in the velocity of money, meaning that money is not moving through the economy as it once did. This means that increases in the money supply are not getting spent. And as we all know, money must be spent to cause inflation. This is why economists are not overly concerned about the recent rapid rise in the money supply causing inflation.

So here are the four easy charts:

• This first chart shows the correlation between the adjusted money supply and inflation. The M2 money supply is adjusted by subtracting real GDP. This amounts to the excess money beyond what is needed to grow real GDP. This has the strongest correlation with inflation. Inflation is measured by the implicit GDP price deflator, which measures the actual items that were spent in the year vs. a previous year's base price. You can use PCE or CPI, but the relationship is very similar. (Also I'm using an 8 year moving average because this gives the strongest correlation between the two variables. The correlation is very weak in concurrent periods, and gets a little stronger using 2 and 4 year moving averages.) You can see from this chart that the correlation was very strong from 1968, the first year of the 8 year moving average, through the end of 1990. R = 0.95 and R^2 = 0.90. This indicates that 90% of changes in inflation can be explained by the changes in the adjusted money supply. This strong relationship has lead the general public to believe that the two variables are inherently related: That is, that the expansion of the adjusted money supply inevitably leads to inflation.
• The second chart shows the correlation from 1991-2021. You can clearly see that the relationship reversed. R= -0.50 R^2 = 0.25. This indicates that the rate of inflation decreases as the adjusted money supply increases. It shows a moderate to weak relationship in which the increase in the adjusted money supply explains about 25% of the decrease in the rate of inflation. This can probably be explained by the fact that the money supply has seen its largest increases in periods when the economy was in recession and prices were falling. Needless to say, you can see that the former relationship between these two variables does NOT exist anymore and hasn't for 30 years!
• This third chart shows the relationship between changes in adjusted money supply and changes in the velocity of money from 1960-1990. The velocity of money is the frequency of monetary transactions in the economy. You can clearly see that the relationship is negative, as the adjusted money supply increases, the number of transactions decreases. R = -0.63 R^2 = 0.40. This indicates that 40% of the decrease in the velocity of money can be explained by the increase in the adjusted money supply. This is a moderately strong relationship.
• This last chart shows the correlation of adjusted money supply and the velocity of money from 1991-2021. R= -0.98 R^2 = 0.97. This indicates the strengthening of the relationship between increases in adjusted money supply and decreases in the velocity of money. You can clearly see that the more money that is pushed into the economy the less frequent that money gets spent.

So where is all this money going if it is not going into goods and services? Economist largely believe that increases in the money supply probably inflate assets, including real estate, stocks, bonds and all other capital and financial assets. PE ratios have been on the rise for 30 years now. The average TTM PE ratio from 1928-1990 was 13.8 times. Since then it is 21x. The 10-year treasury yield from 1928-1990 averaged 5.17%. Since then 4.19%, and 3% in the last 20 years. The are further examples, but I think you can see that the decoupling of the money supply and inflation has probably benefited asset prices.

TLDR: Increasing the money supply does NOT lead to inflation in products and services like it once did. It now results in a lower velocity of money, more savings and higher asset prices.

 

[brokenheart1]

@curiousspring so it doesn't cause inflation, it just makes it more expensive for everyone to rent or buy a home which is 30%-50% of our expenses.... Sounds like inflation... even if your thesis is correct that food and utilities don't get more expensive.

 

[marlou]

@brokenheart1 This is one of the parts of inflation that gets skipped over.

The three biggest costs to the middle class American are Housing, Health Care, Education. These costs have been increasing throughout the quoted timeline of when inflation and money supply decoupled according to the poster. Education and Healthcare have bordered upon hyperinflation.

The costs are obscured in traditional inflation measures by bigger debt loads for housing, increases in the premiums employer based health care charge their employees, and the student loan debt mountain. The last is now coming to a tipping point as the premium a college degree pays has narrowed for all but STEM degrees over the past decades.

 

[resjudicata]

@marlou

Housing, Health Care, Education.

Aha ! Somebody has been lying to the people when defining these as "non-essential goods and services". Just how dental work is "esthetic" instead of being a health care item.

 

[al1998]

@resjudicata aesthetic* fyi

 

[andy90210]

@marlou So there is no inflation for homeless people...I vote we include housing prices in CPI, bc it is my biggest expense.

 

[marlou]

@andy90210 The CPI does include a housing factor, but its not based on actual housing prices but rather rental prices for a theoretical equivalent house. Yeah, its odd. While there is some good reasons for that, it allows a lot of housing price increases to remain hidden.

 

[shelley]

@marlou Wolfstreet did a nice post on housing costs within CPI vs. Case Schiller (same-house sales index).

https://wolfstreet.com/2021/03/11/h...baloney-but-it-accounts-for-1-4-of-total-cpi/

 

[marlou]

@shelley Nice reference.

 

[resjudicata]

@marlou It wouldn't be "odd" on purpose for political convenience, of course.

 

[wader108]

@brokenheart1 It doesn't cause inflation if your method of measuring consumer price is flawed

 

[resjudicata]

@brokenheart1 Perhaps this won't directly lead to higher food and utility costs, but my electric rate just went up 25%, so obviously something is raising utility costs.

 

[ssl]

@resjudicata Energy costs have gone up across the board because energy producers have decreased production due to demand uncertainty caused by the pandemic.

 

[chesy165]

@brokenheart1 It’s inflation. It’s all part of the business cycle.

 

[resjudicata]

@brokenheart1 Economists have long ago found ways to define essential goods and services such as to exclude most things that ordinary people have to pay for, such as a place to live. They are clever like that.

I mean anything that you buy for long term use can be called an "asset" and tucked away in that column of accounting that isn't used as input when computing inflation. Mental gymnastics is a thing.

 

[poppy14]

@curiousspring You have just confirmed that printing money makes the rich richer. The more these asset prices become inflated, the harder it will be for ordinary & young people to be able to afford them in future.

 

[heavenslight]

@poppy14 Therefore, the printing shall never stop. Until if/when it blows up in our faces.

 

[selramza]

@heavenslight I must be tired. I thought I just read “until it blows feces up in our faces”

 

[resjudicata]

@heavenslight When US loses it’s super power status. Which is basically going to be more than just a financial/economic ruin .

It’s not going to happen. Because if it does, we got a lot worse things to worry about than money.

 

[resjudicata]

I think you are imagining a one-day, apocalyptic event, I think it's more likely that it'll (and I argue that it has been) go through a gradual decline.