down toward $300 billion. This took deficits from roughly 10% of GDP (2010) to less than 3% in 2015. Naturally, no inflation will come during such “austerity”. That’s contraction they say and, of course, the “barbarous relic” crashed.
The Austrians, never in concert with the Keynesians, will argue the meaning of inflation. For them, the huge asset run up in commodities like oil, high-yield debt, and commercial real estate is a manifestation of inflation. If you solve a debt problem with more debt and money printing, you get bubbles. Perhaps you get price inflation later but the economy will pay the price eventually.
The monetarists in the room were getting worried by 2010 as M2 money supply started growing at 10% yr/yr but it has fallen to a more normal 5-6% for the last 4 years. It never followed the meteoric rise of excess banking reserves. So, the monetarists channeling their best inner Friedmans say inflation is a monetary phenomenon and it’s not happening.
I think each of the economic camps has some merit but there’s more. First, the Fed does not control everything. One of the pressure valves they don’t control is the dollar. After 2011 the dollar bottomed out and started up. By 2015, the dollar was rising at a 20% annual rate. Times when the dollar is rising by more than 6% per year are times of deflation- certainly not inflation.
The Fed also can’t control the supply and demand curves of a major commodity like oil. Fracking is a secular cost curve shift for oil supply. Don’t believe that? Just check out the price of natural gas which hasn’t seen an uptick in years despite booming demand. It’s tough to create an ‘inflationary’ mindset when the price everyone sees daily, the price of gasoline, is plummeting.
The Fed also can’t cajole the banks into lending all the money the Fed just printed. So they sit in excess reserves- almost $3 trillion of them up from essentially zero in 2008. As the right hand of the Fed is money printing, the left hand, bank regulation post the Great recession, is tightening credit standards. For subprime mortgages, banks continue to report tighter credit standards. Even for prime mortgages, standards didn’t start loosening until late in 2012. Add in the effects of global regulation, and it’s easier for banks to take the 25-40 basis points from the Fed on their excess reserves and not get yelled at by a regulator.
Finally, the Fed hasn’t yet ignited the fabled animal spirits. The best measure of that is velocity of money. And that has plummeted to 50 year lows and if it were a stock, you’d still short it. It peaked in 2000-2001 and has made a long succession of lower lows. This I believe is the key chart to keep watching. When and if the American consumer and business decides to invest longer term and demand more credit at an ever increasing pace the animal will come alive. February 2016 M2 Velocity posted as a lower low and still below the declining 12-month moving average.
Even so, the times may be changing. The CBO predicts that from here through the next 10 years, budget deficits begin an inexorable climb back towards the $1 trillion per year mark by 2022. The dollar has stopped going up and is now overvalued. Wages are now growing at 2.4% per year and there’s lots of wage bumps coming through the minimum wage mandated increases. Commodities, while far from being bullish, may have stopped going down. The Goldman Sachs Total Return Commodity Index bottomed out at a level down 80+% from its highs to its 1990 level (when the Dow was at 3000).
So what’s an investor to do? It’s time to buy insurance against what seemed so obvious in 2010 and so ludicrous now- the return of inflation. Inflation is the ultimate 60/40 portfolio killer. It decimates bonds and drops the P/E-contraction bomb on stocks. Investors need to build up to 10-15% of their portfolios in commodities and precious metals while these hedges are cheap. Once the animal spirits begin taking inflation upwards, it will be a lot tougher to get in. Buy selectively and on the many moments of weakness ahead of us before the fundamentals truly turn up. You will be glad you did. The murderers row of investors of 2010 were likely early but not completely wrong.
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