In our last article, we talked about the increasing number of zombie companies in the economy, and we identified loose monetary policies for an extended period as the main cause of this phenomenon. In fact, in order to cope with the economical consequences of the covid-19 crisis, central banks all around the world adopted expansionary monetary policies that allowed governments to fund multiple stimuli to support demand. By printing over 3 trillion US$ since the beginning of 2020 (according to the Board of Governors of the Federal Reserve System), the US almost doubled the amount of cash in active circulation. While Wall Street surely enjoyed the incredible amounts of money being injected into the system, many are starting to worry about inflation risks. In fact, there are many present and past examples of unstable economies that governments desperately tried to mend by printing enormous amounts of money, which all ended up with national currencies being worthless because of hyperinflation (the exponential daily price increase of goods and services that can approach 5 to 10% a day). The Weimar Republic (in the 1921-1923 period), Hungary (1946), and Venezuela (today) are all countries whose economies have been destroyed by excessive money printing, and while this surely isn’t the case for the world’s first economy, it is still important to understand the mechanisms behind inflation to explain the current situation in financial markets and the potentially dangerous implications for the economy in the next months.
US M1 Money Supply 1959-2021
Is inflation properly measured?
Inflation is the rate at which the general level of prices for goods and services is rising and, consequently, the purchasing power of currency is falling. In order to measure inflation, governments usually look at the Consumer Price Index, a selection of goods and services that should be indicative of a standard household budget. To do so, governments usually delegate a specific department to track these prices, like the US Bureau of Labor Statistics, which monitors a certain number of households across the country. There are two problems with this measuring method, the first one being the psychological effect of surveys, which inevitably change the outcome of research: since an individual knows his expenses are being tracked, he will be more conservative when it comes to spending because there might be purchases that he doesn’t want the government to know or simply because he will be more aware of his spending than the average person. The second and major issue is that not all of the money being printed is going to be spent on every day’s goods present in the Consumer Price Index, most of it will actually go into the stock market, as the richest individuals don’t need to spend most of their income. During the pandemic, a record amount of liquidity went straight into the stock market because of record government stimuli, and because of people spending less because in lockdown contexts (Check out “Is the Stock Market Extremely overvalued?”). In fact, inflation always manifests itself in one way or another, and currently, we are seeing extremely inflated assets in the stock market.
What to expect
Despite US$ 3 trillion printed in 2020, Federal Reserve officials expect to leave interest rates near zero, at least until 2023, with inflation that should average around 2% in 2021. The reason for that is that there are many factors that determine inflation in addition to money supply: Industrial Output, Employment, and Velocity of Money are in fact three important factors among other minor forces that drive prices up. Industrial Output influences the amount of supply of goods in the economy, driving prices up or down, and when it is not enough to satisfy demand, we get what economists call “Cost-Push” inflation, where workers have to spend a larger part of their salary on an insufficient supply of essentials. On the other hand, too much employment can also be a problem, as wages would skyrocket because of a lack of supply in the labor market, increasing costs for companies and thus causing inflation. But when industrial output and employment are low and there is an increase in money supply, the real risk is to cause “Demand Pull” inflation, a scenario where there is too much money chasing too few goods. In theory, the risk of massive money printing in current conditions is to cause stagflation, where economic growth and employment are low, but inflation is rising. Fortunately, that does not seem to be an issue now because of the Velocity of money, which is basically an indicator used to measure how quickly money is changing hands in the economy. Low-income households would probably spend that money very quickly, thus increasing the velocity of money, whereas richer households would probably invest that money into stocks or bonds, which are not part of the Consumer Price Index. This is probably the main reason why inflation, the way we traditionally conceive it, is still low. Meanwhile, the average P/E ratio of the S&P 500 is at 40x, and it has only been higher in 2002 and before the financial crisis. We have talked many times about the overvaluation of the stock market, and some assets being extremely inflated, especially in the tech world. Extreme hysterically speculative investor behavior is another symptom of a sick stock market, whose only cure seems to be a return to normal monetary policies. Ironically, we might see a stock market crash when the real economy will start going back to normal and the Fed will have to raise interest rates to keep inflation low. The reality is that nobody knows exactly when the stock market will crash because there are too many factors that influence inflation and, consequently, monetary policies. It seems clear though that current valuations are not sustainable and soon or later we will see a strong stock market downturn.
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