August 14, 2020
As the Fed continues to purchase billions of dollars of U.S. Treasury securities each week, market participants are becoming concerned about a resurgence of inflation. That may happen eventually, but not yet. The economy has too much slack for there to be a significant jump in inflation any time soon. We expect the core CPI to rise 1.8% this year and 2.3% in 2021. Runaway inflation is not in the cards.
From the time the recession started in mid-March through today, the Fed has increased its asset holdings by nearly $3.0 trillion, mostly through purchases of U.S. Treasury securities. In the process it has flooded the banking system with reserves. There are currently $2.7 trillion of excess reserves. That means that the banking system has $2.7 trillion of funds available to lend to the business community and to consumers.
When banks make loans they put the proceeds into checking accounts. At that point, the money supply increases. In the past five months M-2 has climbed at an astonishing 45% annual rate. Historically, M-2 grows about 4.0% faster than the inflation rate. With a 2.0% inflation target, M-2 should be growing at 6.0%, not 45%.
Rapid money growth is often the harbinger of a pickup in inflation. While we expect inflation to rise eventually, there will be no appreciable increase any time soon for several reasons.
First. there is simply too much slack in the economy. During a recession actual GDP falls far below its potential growth path. It is hard to imagine any significant pickup in inflation with so many underutilized resources. With a relatively vigorous rebound, that slack in the economy could disappear by the third quarter of next year.
Second, the unemployment rate is 10.2%. While it may fall to 8.7% by the end of this year and 6.5% by the end of 2021, it will not reach the 4.2% full employment level until the end 2022. Wages pressures should be largely non-existent until then.
Third, technology in the form of the internet has greatly reduced the ability of goods producers to raise prices. In today’s world before buying anything, we check the price available on Amazon. We can easily find the lowest price available, get free shipping, and have that item the next day. As a result, goods-producing firms have been unable to raise prices for years. If they do, consumers will purchase that item elsewhere. Service sector inflation, meanwhile, chugs along at about 2.0%. Consumer spending is 70% of GDP and spending on goods is 40% of consumer spending. That means there is currently no inflation in 28% of our economy.
In July, the core CPI jumped 0.6% which is the largest single-month increase in inflation since January 1991. The overall CPI rose sharply in both June and July. However, those increases do not represent the beginning of a sustained pickup in inflation.
During the recession prices of virtually everything fell sharply. The most vivid example is crude oil prices which plunged from $40 per barrel prior to the recession to about $13, but they are now back to $42. Airfares had huge declines totaling about 30% in March and April. They have recovered some of that, but remain 24% lower than where they were earlier in the year. Ditto for car prices. As the economy reopens there is an opportunity for business people to offset some of the steep price declines that originated during the recession, but this is not the beginning of a sustained increase in prices.
The one likely source of upward pressure on inflation going forward is housing. Today home sales are hot. They have recovered from the recession and are currently at their fastest pace since January. At the same time there is a minuscule 4.0 month supply of homes available for sale which is far below the desired 6.0-month supply. The homes that are available sell quickly. In fact, in June the average home was on the market for just 24 days. That is a recipe for rising home prices. Indeed, the Case Shiller index of national home prices rose 4.5% in the past year. A year ago home prices were rising at a 3.4% pace.
Given all of the above, we expect the core CPI to increase 1.8% this year. That is slower than the 2.2% increase in the core rate in 2019, and reflects the sharp drop in prices during the recession. Looking forward we believe the core CPI will increase 2.3% in 2021. If the Fed continues to purchase U.S. Treasury securities and keeps money supply growth humming, it is likely that the inflation rate will climb in 2022 and beyond as the economy once again reaches full employment.