Jake Huneycutt | Jan 06, 2013 02:24AM ET
Milton Friedman once declared that “inflation is always and everywhere a monetary phenomenon, in the sense that it can only be produced by a more rapid increase in the quantity of money than in output.”
Friedman might not have been 100% correct on this, but he was damn close. For instance, San Francisco real estate price inflation can be more easily explained by artificial scarcity resulting from development restrictions than money supply growth. Yet, most instances of nation-wide price increases can be explained by high money supply growth, typically resulting from excess spending by the Federal government, and/or via loose monetary policies from the Federal Reserve Bank.
For this reason, I’ve been watching money supply growth and housing prices closely over the past few months. My view is that stagflation is a real possibility in the upcoming years; perhaps somewhat similar to what we saw in the 1970′s. Such an episode would favor certain investment classes, with real estate, commercial banks, and insurers being most likely to benefit in my view.
It’s extremely difficult to predict rates of inflation or future housing prices with any degree of accuracy, and it normally suffices merely to be correct about the general direction of things. That’s my primary goal.
Unfortunately, it’s complicated by the tug of war that is currently happening in Washington. Even with the fiscal cliff deal, we now have another potential debt ceiling battle. Let’s also not forget another major economic event that will take place over the next year: the implementation of Obamacare. While the past data may point one way, it would be easy for another political event to shift things in another direction.
That said, here’s the data I’ve been looking at.
The Budget Deficit and the Fiscal Cliff Deal
The Federal Reserve’s recent statements regarding an employment mandate are cause for concern, but it’s reckless spending by the current Administration and Congress that worry me more than anything. The chart below shows the U.S. budget deficit as a percentage of GDP since 1947.
Given that the U.S. is a sovereign issuer of its own currency, what this means is that deficits are quickly monetized , and that larger budget deficits mean higher inflation risks. The recent fiscal cliff deal barely puts a dent in this, lowering the projected budget deficit from around $1.1 trillion to maybe $900 billion. Even that is based on the flawed assumptions that higher taxes won’t lead to some contraction in Federal tax revenues and that entitlement spending won’t increase significantly in the upcoming years (a dangerous assumption if there ever were one).
M2 Money Supply Growth in the US
Fiscal deficits should eventually result in significant increases in money supply growth. M2 is the broadest measure of money supply we have available, since M3 was discontinued in 2006, so this article focuses primarily on that measure.
Let’s start out with the basics. The following chart shows the year-over-year growth in M2 money supply since 1982.
YOY charts of M2 growth can be a bit volatile, so one thing I like to examine is a 3-year rolling average of M2 growth. This has some advantages and disadvantages. The big advantage is that it smoothes out the growth rate and creates a more coherent chart that tends to make more sense historically. The disadvantage is that the figures can be skewed upwards or downwards by older data.
M2 versus NGDP Growth
Due to this dilemma, I decided to take a look at M2 growth versus nominal GDP ["NGDP"] growth. The chart below shows M2 growth minus NGDP growth.
We saw another massive jump upwards during the financial crisis. And now we are in the midst of another mini-spike above 5%. Once again, we can examine all of this on a 3-year rolling average, as well.
Suffice it to say, there is a large difference developing between M2 growth and NGDP growth and this has been a common state for much of the past 15 years, with the 2004 – 2008 period providing the sole exception to this rule (and a rather minor exception at that).
M2 Money Supply Growth as a Percentage of NGDP
There are strengths and weaknesses with every chart in this article. My biggest concern with the M2 minus NGDP growth stat is that it fails to look at the M2 growth rate as a percentage of the overall economy. For instance, this stat would measure 15% M2 growth with 14% NGDP growth exactly the same as it would 3% M2 growth with 2% NGDP growth. Yet clearly, the former condition is more likely to lead to problematic inflation, and the high NGDP growth rate may merely be a result of said inflation.
You may notice in this flaw in the above two charts as there are no significant spikes in the highly inflationary 1970′s. In order to compensate for this weakness, let’s examine M2 growth as a percentage of NGDP.
Japan versus the United States
Many have compared the United States’ housing crash with the collapse of the Japanese Asset Bubble, but in my view, there are major differences between the two. The next few charts are very enlightening in showcasing the very different M2 growth patterns in the U.S. vs. Japan.
The first chart shows the basic YOY growth in M2 money supply in Japan from 1980 to 2012.
We can also look at the 3-year rolling average with Japan, as well.
For Japan, this chart starts in 1989. For the U.S. it starts in 2006. For each nation, I pegged this about 12-24 months before the crash. The x-axis is the number of months that have elapsed since the initiation date.
The Case-Shiller Index
Finally, let’s take a look at some Case-Shiller data. Below I examine the 10-city index. The downside with this index is that it’s not as broad of a dataset as the 20-city index. The upside is that the data set runs much longer as the C-S 10 has been around since 1987, whereas the 20-city index was only created in 2000. I examined the differences between the two before and they have typically been very small.
Except, instead of looking at YOY changes, I want to look at quarter-over-quarter (QOQ) and half-over-half (HOH) changes. The reason for this is that housing prices were declining through January / February 2012. Since that point, prices have rebounded rapidly, making the YOY changes a bit deceiving. Indeed, the YOY growth for the Case-Shiller 10 index is now at 3.4%, while the half-year increase is exactly the same! In other words, almost all the gains have come in the past six to nine months.
Below are the quarterly increases in the Case-Shiller 10.
Conclusions
Given the complex myriad of factors that determine inflation, I can provide no answers as to what the future holds. However, the charts in this article at least allow us to get a better sense of the inflationary risks moving forward. In my view, from the data I’ve examined, inflationary risks are rising.
It’s difficult to know how the fiscal cliff deal, the renewed debt ceiling debate, and the implementation of Obamacare might affect things, but assuming a continuation of the status quo, I believe that we would likely see a rise in inflation over the next 12-36 months, that could possibly force the Federal Reserve to re-evaluate its dovish stance.
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