Inflation is Always and Everywhere a Monetary Phenomenon

The title of this week's report is based on a famous quote by the Nobel Prize winning monetary economist Milton Friedman. His view, anchored in the quantity theory of money, is that excessive money creation spawns inflation. Our research suggests that there is value in adopting a monetary framework to assess the long-term inflation outlook. We have examined data from a cross-section of countries, as well as nearly a century of US data, to find that inflation usually accelerates when money supply growth exceeds the growth rate in the economy for an extended period of time.

By our count, the Fed has been printing money at a faster rate than the economy's ability to absorb it since the late-1990s. Too much money chasing too few goods has not yet translated into accelerating inflation. Why? Well, it might be because the excess money is not doing much chasing at all - or, as an academic would say, the velocity of money is declining. Cash hoarding by corporate America over the past few years in response to a heightened sense of geopolitical and economic uncertainty is evidence that this might indeed be the case. An alternative, and more accurate, explanation is that money metrics are not helpful in forecasting inflationary turning points with precision; rather, they provide a roadmap for what will probably occur at some point within the next few years.

We are convinced that excessive money creation in the US over the past several years will ultimately arrest the 25-year trend decline in inflation, if it has not already done so. We have and will continue to dedicate a good chunk of our thematic research to this topic because it carries the potential to dramatically alter long-term investment strategy. A reversal in trend inflation would spell an end to the secular bull market in bonds, and it would point to trend compression in P/E multiples, the closing stages of the relative performance advantage for interest-sensitive equity sectors (e.g., Financials, Retailers), and the beginning of a long phase dominated by value investing.

Feeling the Winds of Change

In the late-1990s, I began writing about what I thought was the making of an important shift in the conduct of monetary policy. The Federal Reserve was flooding the world with dollars in an effort to deflect shockwaves originating from the Asian currency crisis. Not long after that, they organized a bailout for Long Term Capital Management and then printed a mountain of money to safeguard against any potential disruptions stemming from the Y2K changeover. These reflationary steps all occurred in phases of the business cycle when the US was in good shape. It seemed like unusual Fed behavior when placed in the context of the past 20 years. It appeared as though the Fed's policy reaction function was in the process of changing. But why?

The focus for the monetary authorities in the prior two decades was to stamp out incipient inflationary risks. It all started back in the late-1970s, when then Fed Chairman Paul Volcker severely curtailed money supply growth in an effort to check the uptrend in an inflationary cycle that was spiraling out of control. The product of this acute tightening phase was a reversal in trend inflation, but at the cost of the deepest recession in post-war history. By the mid-1990s, it was pretty clear that the policy steps adopted by the authorities had helped to win the war against inflation. By the late-1990s, however, a few Board members started to hint that their battle against inflation might be too successful; that well-entrenched disinflationary trends were at risk of turning deflationary (see the chart above). Here is an enlightening quote of the time from a speech given by Fed Governor Meyer:

But with short-term rates now at zero in Japan and low inflation almost everywhere in the industrialized world, the problem [of a liquidity trap] is taken more seriously by central banks--to the point that it was one of the topics at Jackson Hole.

Governor Laurence Meyer, October 12th, 1999

At the time of Governor Meyer's speech, debt levels in the US economy had reached multi-decade heights (see the first chart below), while the inflation rate was hovering near a generational low. One only has to look back at the Japanese experience in the 1990s to realize that falling price levels, combined with excessive leverage, can produce a corrosive economic outcome. 

"The authorities might be trying to inflate their way out of this problem."

My hunch about the changing nature of Fed policy was finally confirmed by the land breaking May 6th, 2003 FOMC communiqué, when the Committee explicitly recognized the risks of an "unwelcome further decline in inflation" for the first time. Furthermore, they acknowledged that inflation and economic activity were to be treated as separate risks.

We have been believers that this Fed tightening cycle would lag the inflation cycle for quite a while in order to keep the real cost of debt service low, and to attempt to inflate away a big debt problem. The real funds rate is still negative, but there has been little evidence in the way of an upturn in general price inflation (i.e., core CPI inflation might have bottomed, but it remains very low). We have never suggested that a big wave of accelerating inflation is imminent, but we do think that a bottom in the long-term inflation outlook has been set and that accelerating inflation will be more common than decelerating inflation over the next several years (refer to the next section).

The Equation of Exchange

Milton Friedman, a Nobel Prize winning economist, once said that "inflation is always and everywhere a monetary phenomenon". We believe that there is validity in his statement if one examines economic trends over a sufficiently long time span. The basis for his monetary view of inflation is anchored in the equation of exchange that is highlighted below:

M • V = P • Q

Note that M is the money supply, V is the velocity of money (i.e., the rate of turnover of money in the economy), P is the general price level, and Q is real economic activity. Transforming each variable into a growth rate and rearranging the terms results in the following equation:

•    •    •    •

P = M – Q + V

This secondary equation says that the rate of inflation is proportional to the growth rate of money. Or, said another way, inflation will increase when money supply growth exceeds the growth in real economic activity, assuming that the velocity of money remains unchanged. We have taken these theoretical underpinnings and applied them to economic data for the US since 1918. The results are shown in the chart below.

"Are we about to start the next inflation supercycle in the US?"

This chart presents some pretty compelling evidence that underlying trends in inflation usually rise when money growth exceeds real GDP growth for a sustained period of time. The latter development has indeed been the case since 1997. The time we last saw a similar turn of events was back in the 1960s, which ultimately paved the way for the inflationary 1970s. So why have we not yet experienced much inflation? Well, it could be that the velocity of money has declined by enough to swamp the impact of disproportionate monetary growth. Velocity might be in retreat (e.g., cash hoarding by corporate America over the past few years) in response to a heightened sense of geopolitical and economic uncertainty. An alternative, and more accurate, explanation is that money metrics are not helpful in forecasting inflationary turning points with precision; rather, they provide a roadmap for what will probably occur at some point within the next few years.

It is important to note that the strong link between money growth and inflation is not just evident in the USA. It is a robust relationship. We have examined data from a cross section of countries and found that higher rates of inflation typically surface in countries with faster money supply growth rates (refer to the next chart).

"Countries with higher money supply growth rates typically experience higher rates of inflation."

Why Do We Care So Much About Trends in Money and Inflation?

If we are right about the link between money and inflation, and that inflation is likely to rise (modestly) on a trend basis over the next several years, then the way to think about investment prospects needs to change. We have written about the implications of rising trend inflation in detail in past strategy reports, and will briefly touch upon a couple of key themes once again.

The chart above shows the relationship between government bond yields and trend inflation. It's pretty obvious from this chart that the secular outlook for bonds will change markedly if we are indeed on the cusp of a turn in the long-term inflation outlook. We will no longer be looking for opportunities to buy the dips, rather we will probably become more focused on when to sell the rallies.

A change in the long-term outlook for inflation will also affect equity market strategy. Since the early-1980s, P/E multiples have been lifted higher largely in response to the long-term decline in interest rates (refer to the chart above). This will probably turn around. Moreover, a trend reversal in inflation will point to further compression in P/E multiples, the closing stages of the relative performance advantage for interest-sensitive equity sectors (e.g., Financials, Retailers), and the beginning of a long phase dominated by value investing.

Bottom Line: Since the late 1990s, the Fed has been flooding the system with money. Our work shows that inflationary trends mirror monetary trends, findings that are consistent with the quantity theory of money. If past is prologue, then it seems reasonable to anticipate a trend reversal in inflation sometime within the next few years. This means that investors should plan for the end of the secular bond bull market, the secular increase in P/E multiples, the long-term performance advantage for Financials and Retailers, and the trend outperformance of growth- relative to value-based stock selection strategies.

Myles offers an interesting explanation for why we have not seen a dramatic increase in inflation and why he still expects it to come despite the recent raises by the Fed. It is quite a contrast with Gary Shilling's thoughts about deflation. And then there are the few in my camp that think stagflation is in our future. But we need to constantly test our theories, as we do this week in Outside the Box.

Your keeping a look out for inflation analyst,


John F. Mauldin

[email protected]