Why the COVID Response Likely Won’t Ignite Inflation

With the Fed responding to the COVID-19 lockdown’s economic damage with trillions of dollars’ worth of lending and liquidity, it was only a matter of time before people started fearing a massive money supply increase fueling runaway inflation. Based on a slew of articles we have seen recently, that time seems to have arrived. Some of the jitters stem from unlimited quantitative easing (QE) bond purchases and the related increases in bank reserves. Others take the recent jumps in various money supply measures, extrapolate them, and warn an uncontainable genie has left the bottle. We don’t think either case for turbocharged inflation withstands scrutiny, much as similar fears during and after 2008’s global financial crisis didn’t pan out.

The current crop of inflation fears do get one thing right: the focus on money supply. As Milton Friedman summed it up decades ago, inflation is a monetary phenomenon. Too much money chasing too few goods. Hence, major money supply gauges’ double-digit surges amid a sudden halt in economic activity raise the specter of mountains of money chasing a very small pool of goods and services, making prices surge.

Trouble is, this ignores the larger factors at play. In an economic crisis, one of the biggest risks is money drying up, forcing businesses under. The hints of that happening this time were fairly obvious, including the sudden stop in businesses’ sales and a temporarily frozen high-yield corporate bond market. Central bankers have learned a lot since 1929, when Fed policy following the stock market crash reduced money supply and forced a grueling, years-long recession and bear market accompanied by deep deflation. That is what policymakers sought to stave off this time around. Rather than model out the 24.8% y/y rise in M1 (mostly notes, coins, bank reserves and checkable deposits) or 15.9% y/y rise in M2 (M1 plus savings deposits, money market funds and CDs), we think it is more logical to interpret the increase as a sign the Fed isn’t repeating the early 1930s’ errors.^[i] Whatever else happens, we quite likely aren’t staring down a prolonged deflationary decline.

Nor do we appear to be on the verge of perpetually zooming money supply. Aside from QE, these new Fed programs are a one-time deal. They are also a substitution—not much money is changing hands right now, so the Fed stepped in to get funds to the businesses that are cash-starved from the lack of transactions. We aren’t going to call that a wash, but a lot of it probably cancels out.

What matters more for prices over the next few years isn’t how much the Fed enables money supply to increase in the here and now—it is what happens after. Since these programs are largely finite, it seems highly unlikely that money supply will continue galloping. Zoom out, and the past couple weeks’ jump probably looks like a temporary blip—much as M1’s last two jumps above 20% y/y, in 2009 and 2011, were also short-lived.^[ii] Neither drove inflation sky-high, either.

Some will likely argue that even if the Fed doesn’t keep pumping money, simply having all this new cash circulating once the economy gets back to normal will be enough to drive prices higher. While that is conceptually possible, again, it didn’t happen the last two times. Plus, the Fed is charged with keeping inflation stable, and it has a number of tools at its disposal. Sopping up excess is as easy as raising reserve requirements—which it has plenty of bandwidth to do, considering they are presently at zero as part of the Fed’s crisis response. Rate hikes are another tool, and there, too, policymakers have plenty of latitude.

As for QE, we had about six years of it in the wake of the global financial crisis, and inflation mostly hovered below the Fed’s 2% y/y target. This confused most observers, spewing years’ worth of think-pieces about how the monetary system was broken. Some hypothesized that money supply no longer mattered to prices. Yet in our view, QE’s disinflationary track record shows money supply actually does matter—you just have to look at the correct measures. Years of QE did indeed boost the monetary base—notes, coins and bank reserves. But that is the narrowest money measure. The broadest, M4, includes everything in M2 plus everything that functions as money in the real world, including commercial paper. While the monetary base soared under post-crisis QE, M4 didn’t. It fell on a year-over-year basis for a long stretch and crawled afterward. It didn’t accelerate noticeably until the Fed started signaling QE’s forthcoming end in mid-2013, enabling markets to price in a return to normalcy.

The reason M4 didn’t soar? Banks create most of M4’s inputs through new lending. QE discouraged this because it dragged down long rates, flattening the yield curve. Banks borrow at short rates and lend at long rates, so the spread between the two represents their profit margin on each new loan. A flatter yield curve shrinks the spread, reducing the incentive to lend a bunch. That happened during QE, with banks keeping credit standards tight. Loan growth during the expansion’s first several years was the weakest of any modern expansion. As the grim joke went, you could get a loan only if you didn’t need it. That tamped down money supply growth, keeping a lid on prices. A repeat this time wouldn’t shock us.

Mostly, we see the inflation fear renaissance as one more sign sentiment is running its normal bear market course. Looking for the next shoe to drop is a common endeavor as bear markets progress and people get gloomier. That gloom helps keep expectations down, creating a new wall of worry for stocks to climb in the next bull market. We don’t know when that will begin—or if it has already—but whenever it happens, inflation fears may indeed form some of the wall’s first building blocks.