“Inflation” by Sydney Williams
A Caveat – While I spent almost fifty years laboring in the financial markets, I am not an economist; those of you who are may well find errors in my analysis. Keep in mind what I express are my opinions.
“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.”
Ludwig von Mises (1881-1973)
From a lecture, 1958
Are we or are we not, in the early stages of an inflation surge? The question is important because the answer has consequences that affect us all – from the daily cost of bread and energy to investment and retirement accounts.
The President and the Federal Reserve claim inflation is not a problem. On July 19, Mr. Biden spoke at the White House: “Our experts believe and the data shows that most of the price increases we’ve seen are – were – expected and expected to be temporary.” In February, in testimony to Congress, Fed Chairman Jerome Powell said that the growth in money supply, specifically M2, “doesn’t really have important implications.” Upticks in inflation are “anomalous and transitory.” Nevertheless, one wonders. In a July 21 Wall Street Journal op-ed, John Greenwood, chief economist of Invesco and Steve Hanke, professor of applied economics at Johns Hopkins, wrote: “Since March 2020, M2 has been growing at an average annualized rate of 23.9% – the fastest rate since World War II.” The Fed’s target rate for inflation is two percent; however, for April, the CPI was 4.2%; for May, 5% and for June, 5.4%. The PCE (Personal Consumption Expenditures) price index – the index the Fed uses as their primary source for inflation – rose 6.4% in the second quarter versus 3.8% in the first quarter. If inflation is nothing to worry about, try telling that to families living on a median wage or to retirees on fixed incomes. Energy prices were up over 40% between December 31 and June 30, while food commodity prices were up close to 20 percent.
Since the start of the recession in February 2020 (which lasted only two months according to the National Bureau of Economic Research!), the Federal Reserve has retained a policy of near-zero interest rates and $120 billion in monthly bond purchases. When the Fed purchases Treasury’s they add to the money supply. Federal debt now amounts to 119% of GDP. The last time federal debt exceeded GDP was in 1946, in the aftermath of World War II, when it stood at 106% of GDP. The federal deficit for fiscal 2021 is expected to be $3 trillion, much of which will be financed by the Federal Reserve. As the Wall Street Journal noted in their lead editorial on July 29: “You don’t have to be a cynic to wonder if the Fed privately now wants more inflation to ease that rising debt burden.” Paying back borrowed dollars with cheaper ones is a policy decision. Five percent inflation means that $100.00 invested in a Thirty-Year Treasury would be worth $23.00 at maturity, while the interest payments (currently 1.93%) would amount to less than $60.00 (before reinvestment) of a depreciating currency – attractive to the borrower but not for the investor. In 1919 John Maynard Keynes, in an essay entitled “The Economic Consequences of the Peace,” wrote: “By a continuing process of inflation, Governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.” Inflation is a tax that falls most heavily on retirees and the low income.
Fifty years ago (August 15, 1971), President Nixon ended the Bretton Woods Agreement, which called for the U.S. to redeem dollars presented by foreign governments at 1/35th of an ounce of gold. Ending the agreement made it easier for the U.S. Government to finance social programs, without raising the necessary taxes, but making inflation more likely. The Dollar, thus, became a fiat currency, meaning it was backed by the credit worthiness of the issuing government, not a physical commodity, like gold or silver. Fiat currencies lose value during times of economic and political uncertainty. Their numbers can be increased, ad hoc, at the will of the government
In a 1963 talk in India, Milton Friedman observed: “Inflation is always and everywhere a monetary phenomenon, in that it can be produced only by a more rapid increase in the quantity of money than in output.” His hypothesis is expressed in the equation MV = Py, where M is the supply of money, V is its velocity (the rate at which money is exchanged), P is the price level (using either PCE or CPI) and y is real gross domestic product (GDP). Thus, when V and y are constant, an increase in M means an increase in P. On the other hand, increased GDP growth may warrant an increase in the money supply, as well as its velocity. If price stability is the desired outcome, the Fed must carefully monitor the relationship between the supply of money, its velocity and GDP.
But are they, and will they? Over the past several years, the Fed has become politicized and less independent. Today, a former Fed Chairperson, Janet Yellen, serves as U.S. Secretary of the Treasury. Since the end of the last recession in 2009, the Fed, pressured by the Obama and Trump White Houses, kept interest rates at historically low levels. In the past two years, since the onset of the pandemic, the growth in money supply has been high, driven by increased government spending, much of which has been funded by the Federal Reserve’s bond purchases. However, velocity of M2 fell by 21% during 2020, reflecting declines in consumer and business spending caused by COVID. So, inflation was not a concern in 2020. However, with the economy picking up speed, the velocity of money has accelerated, and the money supply continues to expand, creating inflationary pressures. Will that trend continue?
The Federal Government’s proposed spending plans, especially the $3.5 trillion budget plan, will require the issuance of new bonds, along with new taxes that act as a retardant on GDP growth. While GDP is now above pre-pandemic levels, economic growth in second quarter was below expectations, perhaps a warning sign. Higher debt loads have a natural tendency to increase interest rates, something Washington does not want, so there will be pressure for the Fed to continue bond purchases. Using Friedman’s formula, can GDP growth equal the increase in money supply and velocity, without an increase in price (inflation)? The truth is we don’t know, or, at least, I don’t. But I worry.
Debt to GDP is at record levels for a peace time economy. Budget deficits are the highest since World War II. The fiscal 2021 federal budget outlays will represent about 29% of GDP, five percentage points higher than a year ago. Will higher government spending boost GDP growth, or will it impede the private economy? Near the conclusion of his lecture quoted in the rubric, Ludwig von Mises said, “One of the privileges of a rich man is that he can afford to be foolish much longer than a poor one.” The Federal Reserve has a challenge. It must navigate between the Charybdis of inflation and the Scylla of excessive federal spending and debt. Can they do that without debauching the currency? Let us hope so. In his 1919 speech quoted above, Keynes began: “Lenin is said to have declared the best way to destroy the capitalist system is to debauch the currency.” Is that what we are doing?
I am not predicting a return to the 1970s inflation or something worse. But I worry. As a country, we are that rich man to whom von Mises referred. Let us pray we will not be more foolish than we have been.
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