"Inflation is always and everywhere a monetary phenomenon in the sense that it cannot occur without a more rapid increase in the quantity of money than in output," says Milton Friedman.
The concept is an appropriate framework to review what is currently happening in the US economy, particularly given the expectation that economic growth (GDP) will be driven higher in the future based on a new fiscal spending and tax cut plan proposed by President-elect Donald Trump.
The graphic I like to use to follow how the money supply has changed relative to GDP over time is pictured below. The blue line shows the annual rate of growth in the M2 money supply since 1962. The growth rate was relatively high in the late 1960s through most of the 1980s. Inflation during this period is also known to be significantly higher than it is today. By comparison, M2 growth since 1988 has been lower, and likewise inflation has been lower.
But, how does economic growth respond to major changes in the money supply through time? The red line in the graph above shows the size of the US money supply relative to the recorded nominal GDP at the same point in time. What is striking about the statistic is just how little money on a relative basis it took to generate the high economic growth rates experienced in the 1990s.
Whereas, since the year 2008, the US economy has been very weak, but the money supply has continued to grow at a rate of 6% or more per year. The disparity between growth in the money supply and the growth of the US economy during the past 8 years now puts the ratio between the two figures at an all-time high since 1962, and still climbing.
The economic explanations around this phenomenon are plentiful, ranging from aging demographics, to technology displacing workers, to US dollars being hoarded by saving economies doing trade with the US. All are plausible reasons that the US economy has slowed in growth while monetary expansion has been rapid thanks to a very accommodative Federal Reserve since Obama took office. But, why hasn't the lack of GDP growth in contrast to continued high growth in money in the financial system been inflationary?
Inflation only loosely correlated to money supply growth
To answer this question, I point to the change in money supply through time (red line) compared to the rate of inflation (blue line).
The most telling aspect of this data set is that money supply growth is rarely "in-sync" with inflation. At best, if money supply growth rises to the high water marks through history of 8%-10%, almost always inflation has been driven higher. Likewise, if monetary growth breaks below 6% for any length of time, inflation has trended lower.
However, there seems to be another major driving economic force that has taken the inflationary trend line in the US down from almost 6% in the late 1970s to the current sustained low below 2%. And as you can see in the graph above, although the inflation trend line shows a turning point recently, even though money growth has been well above 6%, the actual inflation data since 2015 has been stubbornly below 1%, thanks in large part to the busted oil market. Recent data suggest that the owners of the excessively high level of money in the financial system remain committed to hoard excess dollars rather than turn them loose to chase new goods or services.
What would make the inflation statistics change? The best answer I can find to this question lies in the economic player that can potentially unleash a major portion of the "cash currently on the sidelines" - the US government.
Fiscal spending growth highly correlated with inflation over the past 50 years
The Federal Reserve under Ben Bernanke and Janet Yellen have repeatedly over the last several years commented that monetary policy in the US has been carrying too much of the economic policy load, and that increased fiscal policy measures would be welcome. When it comes to creating inflation, there is ample empirical evidence to support the call for support.
In the graph below, the red line shows the US fiscal spending growth rate since 1962. The annual growth rate has averaged 6.9% since 1962. However, as the graph shows, the growth rate since Obama took office, despite all the negative press about "out-of-control" government spending, has been the lowest in the pre-WWII era.
Based on the evidence provided by the data, investors should ask themselves whether the Federal Reserve Chairs were looking for fiscal policy support to help drive unemployment down, or to turn deflationary pressures around that ensued post 2008. The reality is that faster fiscal spending growth is a very clear means of sparking inflation, with a 0.55 correlation factor through time.
Investors should note that fiscal spending through the past year has accelerated slightly with the Paul Ryan compromise when he took over as House Speaker in late 2015. And, the Fed is now stating that their 2% target now seems achievable, and a December rate hike is now almost certain. However, the spending level continues to hover in the deflationary zone, pending the expected, but uncertain in magnitude, increases that may materialize once Trump is sworn into office.
Based on the table above, one could argue that the Obama legacy might be that he over-rotated toward spending control in his administration, possibly by design in trying to recreate the Clinton 90s (see low growth rate highlighted in green), or more likely because he was unable to work through compromise to get programs approved in Congress. I think it was a combination of both circumstances.
One of the big obstacles to truly reviving fiscal spending growth in Washington is the lack of GDP growth which curtails tax collections and causes unwillingness in Congress to vote for spending increases. A movement to dynamically score the Trump budget will likely free up the fiscal spending machine more than it has been in the past. There is also the Trump campaign promise to rebuild the military and not touch social programs. My expectation is that a Republican led government under Trump's command will spend much more than the market currently anticipates.
What happens if the Excess Money Supply is put to work?
The US financial system, thanks to many years of Fed accommodation, is now primed to explode with inflation if the US government goes on a sustained spending growth path. (See "Fed Trumped, Rates Increase, What You Can Do"). The reason I have high confidence that this will be the outcome goes back to the initial graph in this article which showed the enormous increase in money (M2) in the financial system relative to US GDP over the past 8 years. The ratio currently stands at an all-time high of 70.0% ($13.1T M2 / $18.7T GDP). A more typical ratio over from 1962 through 2008 was in the 50%-60% range.
The dismal economic growth under the Obama administration may truly haunt the US for years to come as the country works to dig out from 8 years of a government that has discouraged job creation by placing costly new mandates on proper behavior through regulation, and used the Federal Reserve to suppress interest rates so it could borrow at 0% interest rates to fund a "progressive agenda."
The result has been an economy in which businesses have refused to invest capital in the US at typical historical levels, instead choosing to do share buy-backs, to scale back in many cases and continue to move operations overseas. As a result, more and more US dollars created by trade with US multinationals that moved production piled up overseas to avoid taxation by the IRS creating a very large Excess Reserve balance in the financial system.
The Obama legacy of $2T in excess reserves in the financial system is now left for Trump to deal with. If unleashed on the US economy, it can have a measurable impact on the US economy. But, what will the impact be?
Bear market underway for long duration, low coupon bonds
The main question will be how much will the Trump plan create real growth and how much will be inflationary. One thing is certain, anyone holding long duration bonds (NYSEARCA:TLT) (NYSEARCA:IEF) (NYSEARCA:CIU) (NYSEARCA:LQD) (NYSEARCA:AGG) with 4% or less coupons trading above par value will very likely take substantial investment losses in the bond market reversal now underway.
Since Trump was elected, the global bond market is reported to have lost over $1.7T in value in November. Even if the intent is to hold a long Treasury bonds to maturity, low coupon rates expose investors to on-going economic losses relative to inflation until the bonds re-price substantially lower.
One reason the market is shifting down in price so rapidly is the ease of selling that can be done with bond ETFs. The flight out of ETFs which invest in these bonds can create an unstable economic stampede as holders of the funds flee to escape what is likely to be a continued dramatic drop in valuation. The recent bond market yield curve increases post the Trump election are just the opening shot over the bow signaling a battle to return the US economy to a normal growth rate of 4%.
The biggest casualties in the battle will be investors who cling to the false hopes of the Obama administration, echoed by the Yellen Fed, that rates will be "lower for much longer," for the perverted reason of allowing the government to continue to borrow money at ridiculously low rates. The people have spoken. The failed Obama economic program is about to become history. Look for US interest rates to normalize over the next 12-18 months and the bond market to be in turmoil during the transition.
As bonds increase in yield toward historical norms, beware that broad stock market indexes (NYSEARCA:SPY) (NYSEARCA:DIA) (NASDAQ:QQQ) will need to reset based on how high interest rates must go to finance the Trump plan, and how much inflation expectations move relative to actual real economic growth.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Active investor in fixed income bond market. Portfolio duration is low with 0% exposure to US Treasuries.