Q. Does the record surge in M2 mean that higher inflation is inevitable?
A:
You don't have to be a monetarist to look at the 27% surge in M2 over the past year—easily a record—and wonder if it might, possibly, have some implications for the future path of inflation. The relationship between money supply growth and inflation is not consistent, but that doesn’t mean it’s always safe to ignore the money data.
Moreover, the current spike in M2 growth—due to Fed asset purchases, which increase private sector non-bank deposits—will not be reversed, even after the economy recovers. Central banks everywhere are terrified of outright declines in the nominal money supply, because they are rare and are associated with depressions, rather than garden-variety recessions. In other words, the Covid-induced increase in M2, relative to the level of nominal GDP—even after the recovery—will prove permanent.
M2 growth will slow sharply in the spring, on the anniversary of the onset of the Covid crisis; by May, the year-over-year rate will have halved. But that would leave it at about 13%, comparable to the fastest growth rates seen during periods of very high inflation in the past. Over the course of this year, the federal government is set to borrow about $3.3T, similar to last year, but the Fed's purchases will be much smaller, just under $1T. That means the M2 increment from public borrowing will be much smaller than last year. We reckon that the increase in M2 this year will be about $2½-to-$3T, depending on what happens to bank lending and bank purchases of Treasuries. This implies that M2 will rise by some 13-to-16% in the year to December.
By the end of this year, then, the aggregate increase in the money supply since Covid struck likely will be 40%-plus. Nothing like this has ever happened before. Real GDP over this period likely will have increased, net, thanks to the stimulus, but not by much; about 6% on our forecasts, though the margin of error here is large. The point here is that the only way for such a huge surge in the money supply not to drive up inflation is for the velocity of circulation to rise in line with the rebound in GDP, and no more.
That's entirely possible. It might even be a reasonable base case forecast. But that forecast would only have to be slightly wrong for inflation to rise appreciably. And that's the point here: If you think there's going to be no sustained increase in inflation post-Covid—and that is the Fed's position—then you have to be dead right about money velocity rising only as far as necessary to accommodate the increase in real economic activity. Any more than that, and inflation will rise.
The gap between returning to the prior trend in velocity—implying an explosion in inflation—and rising just enough to facilitate the recovery, is very wide. And in any of that gray area, inflation rises. The question then becomes one of degree; how far does inflation rise, and how quickly does it increase. Fed officials are confident in their ability to deal with rising inflation, but their tools have not been tested since the early 1980s. Back then, the Volcker Fed crushed inflation, but at a very steep price.
Today's Fed might ultimately prove to be right, about everything. But their lack of self-doubt—if it is as strong in private as it is in public—is troubling. Today's circumstances—and tomorrow's—have no precedent, and making contingency plans for outcomes other than the benign base case seems to us to be a sensible approach for both the Fed and investors.
Ian Shepherdson, Chief U.S. Economist
