Part of the Investor Opportunity series from Fisher Investments and TheStreet

Shortly after many states implemented widespread lockdowns in response to the COVID-19 pandemic, the Federal Reserve (Fed) and U.S. lawmakers responded by allocating trillions of dollars in direct payments to individuals and loans or credit to banks, businesses and municipalities. The goals of these fiscal and monetary measures are to help blunt the economic effects of business closures and shore up confidence and liquidity in the financial system. Given the size of the response, some have warned rampant inflation will follow. However, we don’t think that outcome is likely in the immediate future.

Inflation isn’t often a primary concern during a recession.

First, a quick definition: Inflation is an increase in the general level of prices for goods and services throughout the economy over time. Conversely, deflation is a broad decrease in prices. During a recession -- like the one resulting from COVID-19-related lockdowns -- money can stop flowing through the economy for many reasons. In such instances, inflation often slows, sometimes even shifting to deflation. Thus, a potentially more likely risk during an economic contraction is a lack of money (and lending), causing some businesses to shutter when they can’t access the funds they need to stay afloat. A historical example of this is the period following the 1929 stock market crash, when the Fed made a series of errors that tightened monetary policy and contributed to a historically deep, years-long depression accompanied by sustained deflation.

However, this time around, the Fed and lawmakers responded with measures to keep money moving despite the lockdowns’ economic fallout. Rather than a traditional “stimulus” meant to create demand where there is none, this year’s measures aimed to provide liquidity to areas of the market that the Fed considered necessary to shore up business confidence. Further, the U.S. government spending packages are largely intended as a substitute for lost revenue and wages. These fiscal and monetary responses included some good and some bad, in Fisher Investments’ view, but we don’t think high inflation is a likely outcome right now. A closer look at recent history and what drives inflation helps explain why.

Unprecedented Measures

Unprecedented measures during the last major downturn didn’t cause runaway inflation.

Fundamentally, inflation stems from too much money chasing too few goods, so money supply is a key variable for inflation. However, there are many different ways to measure the money supply. The monetary base is the simplest and narrowest measure. It’s the sum of currency in circulation and bank reserve balances at the Fed, and it surged this spring. M2 money supply is a little broader and includes notes, coins, bank reserves, checkable deposits, savings deposits, money market funds and certificates of deposit (CDs). M2 also jumped this spring, rising nearly 18% year-over-year in March.[i]

These spikes prompted some to argue high inflation will likely result.

But, in our view, these readings simply reflect a huge one-time influx of liquidity into the system during a crisis -- not a trend likely to be recurrent. So Fisher Investments believes it’s a mistake to extrapolate these figures far into the future. For example, following the fiscal and monetary responses to the 2008-2009 Financial Crisis, M2 rose over 10% year-over-year in January 2009, as well as each month during the first quarter of 2012, but then M2 growth eased to lower levels.[ii] And while headline inflation oscillated around those times (Exhibit 1), it still remained muted despite a ballooning monetary base and rising M2 (Exhibit 2).

Inflation never got out of hand last cycle …

Source: Federal Reserve Bank of St. Louis, as of 06/04/2020. Consumer Price Index year-over-year change, 01/01/2009–04/01/2020.

Source: Federal Reserve Bank of St. Louis, as of 06/04/2020. Consumer Price Index year-over-year change, 01/01/2009–04/01/2020.

...even though the monetary base ballooned and M2 increased.

Source: Federal Reserve Bank of St. Louis, as of 06/04/2020. Monetary Base and M2, monthly, 01/01/2008–04/01/2020.

Source: Federal Reserve Bank of St. Louis, as of 06/04/2020. Monetary Base and M2, monthly, 01/01/2008–04/01/2020.

One way to gauge future inflation is to watch the velocity of money.

Clearly, large increases in the monetary base and M2 by themselves aren’t enough to trigger high inflation. For inflation to rise, you typically need to see more lending and new money rapidly circulating in the economy via spending and transactions. In our fractional reserve banking system, banks typically create most new money supply through lending, and then those dollars circulate through the economy via an ongoing chain of transactions.

Once new money is in the economy, the velocity of money indicates how many times a dollar changes hands over a given time period. If the velocity of money remains low, inflation usually isn’t a huge worry. Since the 2008–2009 bear market, M2 money velocity has remained subdued and has even dropped to a multi-decade low in recent months, as shown in Exhibit 3. Ultimately, the velocity of money (or lack thereof) helps explain why surging M2 money supply doesn’t necessarily lead to broadly rising prices throughout the economy. 

Velocity of M2 Money Supply Remains Low

Source: FactSet, as of 06/04/2020. M2 Money Supply year-over-year percentage change and M2 money levels, monthly, 06/29/1990–01/01/2020.

Source: FactSet, as of 06/04/2020. M2 Money Supply year-over-year percentage change and M2 money levels, monthly, 06/29/1990–01/01/2020.

While far from the only factor, Fisher Investments believes the velocity of money has remained muted partially due to quantitative easing (QE) -- the Fed’s long-term bond-buying program. Along with other measures enacted this spring, the Fed also restarted QE indefinitely.

Under QE, the Fed buys long-term bonds to give banks more reserves -- hoping they use those funds to lend. However, QE lowers long-term bond rates, which also reduces banks’ potential profitability on new loans. Consequently, last time around, rather than use their excess reserves to lend, many banks ended up simply parking new money at the Fed -- preventing that money from circulating through the economy. As long as banks don’t have much of an incentive to enthusiastically increase lending, money likely continues moving slowly, which should prevent inflation from overheating just yet.

What to Look for Moving Forward

If you want to monitor potential inflation moving forward, focus on broader measures of the money supply, new lending and the velocity of money. And if inflation does start to pick up some, it still may not be cause for concern. Inflation often starts off gradually and builds slowly -- giving you time to assess the likelihood of it becoming a larger issue or not. Additionally, the Fed has disinflationary policy tools -- such as raising the fed-funds target rate -- that it can employ to help fight inflation, if needed.

So don’t fret inflation just yet. There may be a time when inflation heats up down the road, but we don’t think it seems likely right now.

Investing in stock markets involves the risk of loss and there is no guarantee that all or any capital invested will be repaid. Past performance is no guarantee of future returns. International currency fluctuations may result in a higher or lower investment return. This document constitutes the general views of Fisher Investments and should not be regarded as personalized investment or tax advice or as a representation of its performance or that of its clients. No assurances are made that Fisher Investments will continue to hold these views, which may change at any time based on new information, analysis or reconsideration. In addition, no assurances are made regarding the accuracy of any forecast made herein. Not all past forecasts have been, nor future forecasts will be, as accurate as any contained herein.

[i] Source: Federal Reserve Bank of St. Louis, as of 06/04/2020. M2 money stock monthly y/y increase of 17.99% in March 2020. https://fred.stlouisfed.org/series/M2SL.

[ii] Source: Federal Reserve Bank of St. Louis, as of 06/04/2020. M2 money stock monthly y/y increases of 10.29% in January 2009, 10.25% in January 2012, 10.16% in February 2012, and 10.12% in March 2012. https://fred.stlouisfed.org/series/M2SL.