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The widely-held expectation that the U.S. is heading towards high inflation in the next five years has recently caused commodity prices to surge and the greenback to decline.However, I think that the argument for high inflation is too narrowly focused on the “money supply” part of the inflation equation and not enough on “money velocity.”
The general argument for high inflation is as follows: economic stimuli and large government deficits over the past couple years have increased the money supply. Now that we’re out of the recession, imagine all of those extra dollars spent in a revived economy, and that’s why many investors think we have a perfect recipe for high inflation.
However, I think that too many people ignore the fact that money “velocity”—the rate at which money is spent on goods and services—will be structurally lower than pre-recession levels for a few main reasons:
1) The U.S. personal savings rate will remain higher.
The past decade saw the lowest personal savings rates in the last 60 years. The average historical savings rate (by month) used to be about 6%, but in the period from January 2005 to the start of the financial crisis in September 2008, the savings rate rarely passed 2.5%, and in fact dropped below 1% many times. That’s partially why the financial crisis hit so many people so hard: a deep recession occurred at a time when people had historically low levels of savings to hold them through.
For the foreseeable future, Americans won’t make that mistake again. The “irrational exuberance” about our economy is gone, and people understand they need more money in the bank for the rainy-day fund when things go south again. Expectations for government cutbacks in entitlement programs like Medicare and Social Security have driven higher savings especially among middle-aged Americans nearing retirement. That’s why the personal savings rate has increased substantially from 1-2% to where it is today at 5.5% (data from the St. Louis Fed).
The fact that people have swung from saving virtually nothing to saving 5.5% of their disposable income demonstrates that the psyche of the American consumer has changed. Higher savings rates, of course, don’t automatically translate into lower inflation rates, as the 80’s demonstrated. But since consumer spending is a significant driver of GDP and inflation (think “multiplier effect”), it’s still very possible that higher savings rates could tamper inflation.
2) The commercial banking industry will continue to abide by stricter lending standards.
Of course, a higher savings rate itself won’t necessarily hold down inflation if the banks just turn around and lend out that money at a very high rate. However, the banks have adopted stricter lending standards that are here to stay.
In the run-up to the financial crisis, everyone now knows about the almost laughable lending practices that a lot of banks engaged in, which led to high default rates. Not only have banks been smacked from a financial standpoint because of lax loan standards, but the government has cracked down hard on them too. Whereas before the financial crisis, regulators wouldn’t closely scrutinize large numbers of loans, now they send more people more frequently to review bank loans because of the public backlash for not “doing their job.”
For both business and regulatory reasons, banks are resetting their loan standards to “80’s and 90’s” levels as opposed to what we saw in the last decade. In particular, HELOC (Home Equity Line of Credit) used to be a critical lifeline and engine for small business growth. If a small business needed a working capital loan or a loan to purchase equipment, banks allowed the business owners to use their home equity as collateral. That worked well since home prices kept rising. However, after the real estate market plunged, home equity was greatly diminished and in some cases wiped out. Banks aren’t extending HELOC as much anymore, and a weak real estate market for the next few years shouldn’t change that.
Higher savings rates and lower lending rates combine to hinder inflation because money isn’t flowing as quickly throughout the economy. However, investors should watch to see if corporations begin to significantly increase their wage expenses, perhaps a sign of corporate “dissavings” if they feel confident enough about the market.
3) Interest rates can only rise, but “QE3” is still anyone’s guess.
This isn’t a novel idea, but it’s important. Interest rates remain close to zero, so the Fed can only raise them from here. When that happens, it makes borrowing costs rise, so demand for loans from businesses and consumers will likely fall, slowing the flow of money in the economy.
QE2, the Fed’s program to purchase Treasury bonds on the open market and therefore pump more money into the economy, is set to expire in June. There are decent arguments on both sides for whether there will be a “QE3” afterwards since GDP growth recently slowed to an annualized rate of about 1.8%. Whether or not the Fed decides to stop QE2, or start a new program, will have an impact on inflationary expectations but it’s difficult to speculate what the Fed will decide at this time.
4) Higher structural unemployment means less people will be earning and spending money.
This has also been said before, but it’s worth repeating: some of those jobs we lost in the recession aren’t returning. To cut costs, some businesses have outsourced American jobs overseas. Others have just grown accustomed to operating leaner workforces after slashing jobs during the recession, and they’re now enjoying higher profitability and productivity as a result. In April of this year, the Federal Reserve Board forecasted unemployment north of 6% for the next few years.
The immediate result isn’t difficult to understand. With less people earning and spending wages than in the pre-recession economy, that will serve to hold back inflation. Even as wages grow for those who do have jobs, that growth isn’t likely to offset the higher structural unemployment level.
5) Home equity, the largest retirement “nest egg” for most families, will remain weak.
Real estate value and housing appreciation comprise a critical underpinning of consumer sentiment and spending, and thus have an indirect impact on inflation. For most American families, the home is the largest (and only significant) source of wealth they have. Consequently, it’s also the asset that families most rely on to provide for retirement.
A continued, weak real estate market has helped drive higher savings in financial institutions, since families are looking for other ways to supplement their retirement pool. And the housing market is one sector of the economy that hasn’t rebounded particularly well after the recession. Recently in January, worries of a double dip in housing prices were revived when data showed that housing prices fell in nearly all major markets across the country. Tighter mortgage standards have restricted demand for mortgages, while the high number of foreclosures has boosted the supply of cheap homes, which has suppressed home prices.
I won’t comment on the likelihood of a “double-dip” in housing prices, but as Treasury Secretary Geithner appropriately said last week about the recovery in home prices: “we’ve got several more years to go.”
Middle-aged people who were hoping to rely on home equity for a large chunk of their retirement have been hit the hardest, and they’ll likely continue to tighten consumer spending and save that money in alternate investments.
6) The government will make meaningful measures to reduce the deficit.
It may sound crazy, but I think our elected leaders will get their act together to meaningfully tackle the large deficit. The market may have to wait until after the next election until there’s some closure on a deal, but one thing is for sure: reducing the deficit is #1 on the agenda for both parties now that we’re removed from the recession. The only difference is how each party prefers to fight the deficit, but I think that there has been solid indication that entitlement programs and defence spending—the largest areas of the federal budget—are finally on the table.
Tackling the deficit doesn’t directly impact money velocity or supply, since cutting spending or raising taxes just transfers money from one set of economic actors to another. However, the reduced GDP growth that comes from tackling the deficit can cause money velocity to decrease. Once investors see that a real budget deal is imminent, they’ll understand a huge source of potential inflation has been diminished because of likely slower economic growth.
When predicting future inflation, investors can’t just look at the growth in money supply alone. Money “velocity” plays just as large a role in determining inflation. For example in 2009, despite hundreds of billions of dollars of stimulus and bailouts, lower money velocity actually caused deflation for a few months. Now, two years removed from the bottom of the recession and after another round of quantitative easing, this continued lower money velocity has kept inflation below the historical average at 3.5% (annualized), even amidst spiking energy and food prices.
There are good reasons why the economy will have structurally lower money velocity than pre-recession levels, and investors can’t ignore the anti-inflationary consequences of that.