Booming Prices

Summary

• The Fed continues to expand its balance sheet, the federal government continues to send out Covid relief checks, and the Fed continues to effectively monetize most if not all of this monetary "stimulus."
• The public has been hoarding money like never before, likely as a response to all the uncertainties raised by the Covid crisis.
• Unless and until the Fed reverses its Quantitative Easing efforts and/or raises short-term interest rates, declining fear, rising confidence, and strong economic growth are likely to fuel a palpable rise in inflation for the foreseeable future.

The Fed continues to expand its balance sheet, the federal government continues to send out Covid relief checks, and the Fed continues to effectively monetize most if not all of this monetary "stimulus." Although this "stimulus" hasn't yet resulted in a significant rise in the general price level, we do see increasing - and potentially troubling - signs of booming prices in certain areas of the economy. I've been arguing for some time now that the Fed's profligate monetary expansion has not been inflationary because it has simply accommodated a similar, robust increase in the demand for money. But the demand for money of late is surely declining (while the supply is not) thanks to 1) rapidly spreading vaccinations and a significant increase in the US population's natural immunity, 2) increasing consumer confidence, 3) the ongoing relaxation of lockdowns and mask mandates, and 4) impressive signs of economic recovery.

In my view, we are already seeing early signs of what will eventually prove to be a meaningful increase in inflation, and this process is likely to play out over the next few years. Inflation seems sure to rise, but we do not yet know by how much.

Chart #1

As Chart #1 shows, the Fed has allowed the M2 money supply to increase at an unprecedented pace since February '20. M2 has surged by $4.2 trillion (27%) in the past 13 months, and has been rising at a roughly 15% annualized pace in recent months; that is far and above the 6.5% annualized rate of M2 growth in previous decades. The vast majority of the outsized increase in M2 can be found in bank savings and deposit accounts at the retail level. The public, in other words, has been hoarding money like never before, likely as a response to all the uncertainties raised by the Covid crisis. I calculate that M2 currently is about $2.3 trillion above its long-term growth trend. That's an extra 12% increase in the amount of money than would be held in "normal" times. If the public decides to reduce its cash holdings relative to income, this "extra" M2 could fuel a 12% increase in inflation over the next few years.

Chart #2

Chart #2 shows the Manheim Used Vehicle Value Index in both nominal and inflation-adjusted terms. Since February 2020, used cars have jumped 22% in price! In real terms, they are almost back to where they were during the boom times of the late 1990s.

Chart #3

Used cars appear to be in very short supply (relative to demand), and new car sales these days are about as strong as they have ever been, as Chart #3 shows. No matter how you look at it, the demand for new and used cars is robust. Strong demand could be due at least in part to all those stimulus checks, coupled with very low borrowing costs and the public's pent-up demand to get out and about following a year of being shut in.

Chart #4

Chart #5

Charts #4 and #5 show the prices paid component of the ISM manufacturing and service sector surveys. The vast majority of businesses are paying higher prices for stuff these days. That last time we saw such high levels - in the late 2000s - we also saw elevated levels of the CPI, which averaged 4% per year from mid-2005 to mid-2008.

Chart #6

Chart #7

Housing has also been the beneficiary of unusually strong demand, as Chart #6 shows. In real terms the average home price in the US is now just about as high as it was at the peak of the 2006-2007 housing boom. Prices rose by about 11% last year and continue to move higher (it's not uncommon to see Zillow and Redfin reporting asking price increases these days, at least in local neighborhoods I follow). I expect to see this continue, fueled by exceptionally low mortgage rates and lots of cash in people's pockets. Plus, the Fed has vowed to not interfere with any of this until late next year.

As Chart #7 shows, it takes about 18 months for big moves in housing prices (blue line) to show up in the housing component of the CPI (red line). As Milton Friedman taught us, the lag between monetary policy and inflation can be long and variable.

Chart #8

The elephant in the rising price room is the US equity market. The S&P 500 is up over 20% since its pre-Covid high in February '20. According to Bloomberg, the market value of all US equities has increased over that same period by about $10 trillion.

Chart #9

Non-energy commodity prices (red line, Chart #9) are up over 20% from their January '20 highs. A good portion of that rise can be attributed to a weakened dollar (blue line), but a weaker dollar is symptomatic of easy money and a precursor to inflation (as we saw in the 1970s). Note also that the dollar weakened in the 2005-2008 period and commodity prices also rose - and inflation increased meaningfully, as noted above.

Chart #10

The price of copper has jumped over 40% since the highs of January '20. This undoubtedly reflects booming construction activity around the world, but also can be attributed in part to easy money conditions in the US.

Chart #11

Finally, as Chart #11 shows, one driver of higher prices is simply a decline in the market's level of uncertainty, as reflected in the declining Vix "fear" index. The uncertainty that prevailed throughout most of 2020 undoubtedly contributed to the public's hoarding of cash, and now this dynamic is unwinding.

Unless and until the Fed reverses its Quantitative Easing efforts and/or raises short-term interest rates, declining fear, rising confidence, and strong economic growth are likely to fuel a palpable rise in inflation for the foreseeable future.

Unfortunately, that in turn will give way - as has always been the case after periods of rising inflation - to tighter money, higher interest rates, and eventually (2023?) to sharply weaker economic growth.

Original Post

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.