Will the Stimulus by the Fed and Congress Cause Inflation?
Inflation is a topic that is starting to get more attention on Wall Street. The Federal Reserve and Congress took strong measures to combat the rapid decrease in economic output caused by COVID-19. The Fed implemented many programs available to struggling businesses, while the government passed a massive stimulus package to help many individual Americans. This coordinated approach is expected to prop the economy during these difficult times and help speed the recovery. However, investors are now asking if these actions may have consequences down the line through higher inflation levels.
Inflation is defined as a rise in the general price level. Inflation is seen as negative, however, that is not always the case. In fact, a moderate amount of inflation is healthy for the economy, which is why the Fed has traditionally kept a 2% target. Inflation becomes an issue when it rises faster than expected.
Inflation erodes purchasing power; therefore, it is important at minimum to keep up with it. Suppose you had $100,000 in the bank sitting in cash 20 years ago, today that same amount would need to grow to $150,000 in order to buy the same goods and services.[i] That is why leaving money in cash for a long period of time is not prudent.
According to a publication by the Federal Reserve Bank of San Francisco, there are two types of inflation, demand-pull and cost-push.[ii]
Demand-pull inflation is caused when demand for goods and services is greater than the supply. For instance, if we were all given $1 million gift today and decided to spend it right away, we would all demand more items and businesses would not be able to keep up with the increased demand. As a result, businesses would respond by increasing their prices.
Cost-push inflation occurs when prices of production inputs increase. Some may remember the rapid rise in oil prices in the 1970’s that led to extremely high inflation. Another example would be if unemployment is extremely low, which could cause wages to increase rapidly and to offset higher cost, companies could raise the price of their goods and services.
Coming back to the current environment and inflation, some have been sounding the alarm that the stimulus by the Fed and Congress will cause high inflation in the future. Of course, the short answer is that nobody knows for certain, but we wanted to share some of the data points we are tracking to help us determine if we should be concerned.
The following series of graphs are from the Economic Research page of the Federal Reserve Bank of St. Louis.[iii] We could write about each chart in its own Market Update, but in order to keep the narrative concise, we will go through them quickly.
The first chart is the M2 money supply. This is the broadest definition of money and includes checking, savings, and money market accounts. We can see that the money supply has increased substantially over the last few months which is what has some investors concerned. Using the $1 million gift example, this is where people would park that money until they decided how to spend or invest it.
To confirm the increase in the M2 money supply, we looked at the one-year percentage change (second chart). Indeed, we see a sharp increase, which we have not observed since this data has been tracked by the Fed. However, this alone is not enough to cause inflation.
Back to our $1 million gift example, we assumed that everyone was given this gift and decided to spend it right away. We need both things to occur to cause inflation, increased money supply and increased spending. Looking at the velocity of the M2 money supply (chart three below) we can observe that the increased money stock is not being spent quickly. Similar to what happened after the Great Recession, which is why the Fed quantitative easing did not lead to high inflation.
We now turn to what the bond market believes will happen with inflation over the next 10 years. For that we look at the difference between the 10-year nominal US Treasury bond and the 10-year TIPS yield. TIPS are investments to protect against expected inflation. At the moment, this metric informs us that the bond market thinks inflation will average 1.7% over the next decade, which is not alarming.
Finally, we turn to a chart that depicts core inflation over the last 60 years. As we can see, inflation has been subdued for a while now and the pattern would be inline with what the bond market is predicting.
At this moment, inflation fears appear to be unwarranted. However, given that things change quickly, it does not mean that high inflation will not be an issue in the future. That is why the Surevest Investment Committee is data driven and we will let the numbers speak for themselves. At the moment, it is too early to discern the pattern inflation will take in the future, but we will continue to watch the charts to provide us guidance. If signs of high inflation begin to show on the charts, we would adjust the portfolio to minimize those impacts. For example, we would lower our fixed income allocation because bond prices would be expected to decrease, we would move toward companies that are not dependent on commodity input cost, and we would increase our allocation to real assets. As things develop, we will keep you informed.
