Inflation’s sudden jump raised the question, “What’s next?” It’s the right question, but there are two parts to the answer.
To understand where inflation is heading, we need to split that term into its two components:
Price inflation – Higher, specific prices due to increased demand and/or decreased supply (e.g., lumber). These price movements are capitalism at work. Moreover, an uptrend can flatten or turn down as demand/supply factors change. Therefore, we need not worry about price inflation.
Fiat-money inflation – Higher, general prices due to “excess” money supply and higher “velocity” (i.e., the speed of the money supply turnover). These broad price increases are trouble because they represent a permanent cheapening of a currency’s value (i.e., its purchasing power)
“Fiat money is government-issued currency that is not backed by a physical commodity, such as gold or silver, but rather by the government that issued it. The value of fiat money is derived from the relationship between supply and demand and the stability of the issuing government, rather than the worth of a commodity backing it as is the case for commodity money. Most modern paper currencies are fiat currencies, including the U.S. dollar, the euro, and other major global currencies.”
Price inflation is today’s driver
Price inflation is the current driver. With the Covid-19 slowdown, price increases moderated. Now the economy is regaining strength, so the recent inflation rise is due to organizations’ price-setting catching up. (See “Inflation Jump Means Company Pricing Power Is Back…”)
This graph shows the price level returning to its pre-pandemic trend.
Fiat-money inflation is tomorrow’s driver
The inflation worries being discussed come from the significant money supply increase relative to GDP. So far, however, that “excess” money supply has had little effect because it just sits. Its idleness is visible in both reduced turnover and lackluster bank loan growth.
In active fiat-money inflation periods, both turnover and loans rise significantly as people and organizations seek to take advantage of and protect themselves from the currency’s declining value.
The graph below shows the steady moves from the beginning of the Great Recession (October 2007) to March 2021. During this 13-1/2 year period the Federal Reserve increased the money supply faster than GDP growth, and it kept interest rates below the inflation rate (i.e., a negative real interest rate). The sharp moves in the second quarter 2020 were due to the Covid-19 shutdown.
The cumulative percentage changes over this period were:
- M2 money stock = +168%
- Bank loans and leases = +62%
- GDP = +50%
- CPI = +28%
- M2 velocity = (43)%
Note three items:
- M2 money stock (money supply) increase exceeded three times GDP growth
- In spite of ample money supply and abnormally low interest rates, bank loans and leases only tracked GDP growth prior to the Covid-19 shutdown
- A basic economic equation holds true: M x V = T x P (Money supply times Velocity = “Real” transactions times Price level)
On October 2007 — 100 x 100 = 100 x 100 —> 100
On March 2021 — 268 x 57 = 150 (GDP at current prices) —> 153 = 150
So, the 43% decrease in velocity offset the 168% increase in M2. And that means the holders of M2’s $20+ trillion in liquid assets are sitting and waiting, earning minimal interest while losing purchasing power.
The bottom line – Enjoy today and prepare for tomorrow
Price inflation is onstage today and its performance looks okay.
Fiat-money inflation, meanwhile, is offstage. However, it is fully costumed and waiting in the wings. Will it enter? Actually, the question should be, “When will it enter?”