By Philip Lawlor, head of Global Investment Research
The recent rebound in inflation breakevens (a gauge of market inflation expectations based on inflation-linked bond yields) and the sharp drop in real yields have sparked worries about stagflation amid persistently low economic growth and supply-chain disruptions and shortages.
FTSE US long-dated breakeven inflation and real yields (%)
Source: FTSE Russell / Refinitiv. Data through August 17, 2020. Past performance is no guarantee to future results. Please see the end for important disclosures.
Focusing on the acceleration of US money supply growth alone…
Inflation concerns in the US have been stoked in part by the huge expansion in M2 money supply growth (chart below, bottom), propelled by renewed Federal Reserve asset purchases and a pandemic-fueled surge in bank deposits. Signs of Fed willingness to let inflation overshoot its longstanding 2% target may also be feeding these perceptions.
…misses the simultaneous collapse in money velocity
As the chart below shows, the rise in money supply has been matched by a collapse in velocity, or the number of times a dollar is spent in the economy. Ultimately, money is created via the banking system (i.e., bank credit creation), not central banks, but money multipliers between base money (created by the central bank) and credit growth need to be stable for monetary-easing measures to reach final demand. The decline in velocity indicates this multiplier effect is going into reverse.
US M2 money supply growth and velocity
Source: FTSE Russell / Refinitiv. Data through August 17, 2020. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
A replay of the post-GFC period?
Similar inflation fears arose in the aftermath of the GFC, when the Fed’s quantitative-easing (QE) initiatives also drove sharp gains in money supply growth. However, a sustained rise in inflation never materialized. M2 velocity slowed as bank regulations tightened, risk appetite waned, and households and businesses hoarded cash—even while the Fed succeeded in stabilizing inflation expectations.
Bottom line, it’s best not to read too much into M2 growth without also monitoring drivers of money velocity and aggregate demand.
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