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Economy in Brief

Tight Money Isn't Funny- But Too Much Growth Can Make You Choke
by Robert Brusca  January 28, 2022

So... there it is, the paradox of the central banker…How much is enough? How much is too much? How much is too little? What happened to Goldilocks?

Back in the early 1980s, monetary experimentation was rampant. I worked at the New York Federal Reserve Bank back in those early days (1977-1983). My look back at the research and experimental looks at money (M1, M1a, M1b, M2 MZM…L, etc.) leaves me with the feeling that while there was a lot of research there was more investigation than there was learning. Subsequently, the Fed left the quantity of money to the wind and focused more on the price of money by targeting interest rates. But that does not mean money does not matter. It just means that money is not targeted. In fact, the Federal Reserve in the U.S. even STOPPED PUBLISHING M2 money supply numbers weekly. Shame!

The Fed in the U.S. further loosened constraints on itself by claiming to target some (unspecified) average rate of inflation and the ECB followed suit, dropping the less-than 2% objective for a 'higher' (also unspecified) 2% 'average.' So now central banks have a known objective for inflation (2%) which they are evaluating by looking at an unknow benchmark - some average of actual inflation. This, of course, leaves markets more mystified than before because we really don't know what the central bank is looking at to make policy. Since inflation has jumped so much, there is an enormous difference in what you see for inflation depending on which average you look at. And central banks think they are doing a 'excellent job' at communication!

Can we be anything but NOT SURPRISED that all this has led to rampant inflation?

Remember to genuflect in front of this chart...
The 12-month money supply growth in the EMU is 7%, in the U.S. it is 13.1%, in the U.K. it is 7.7% and in Japan it is 3.7%. Not surprisingly, inflation in the U.S. is 7.0% (CPI) or 5.8% (PCE), in EMU 5.0% (HICP), in the U.K. 4.8% (CPIH) and in Japan 0.8% (CPI). Not too surprisingly, the inflation metrics more-or-less line up in rank with money supply growth and this is without doing a lot of work to put all inflation measures on common footing or fiddling with lags.

However, you do not have to focus on money supply to understand why inflation sprang up. In fact, I am a little concerned that money supply will be given too much 'credit' (no pun intended…) as a cause of this flare up. I would point the finger more at fiscal policy where government made sure that income or funds (in some fashion) flowed to people when Covid disruption occurred.

This chart of EMU Money and Credit Growth (note the two-scale nature of this chart) underscores that not all money growth becomes loan growth. In the 'old days' banks (and I will use the U.S. example here) were pretty much 'loaned up' as excess reserves were low. Banks (the banking system) would lend as long as they had excess reserves right up to the limit. But as the Fed moved to new operating procedures and to interest rate targeting, excess reserves grew enormously. In fact, the old money multiplier approach became obsolete. You may ask, if banks had excess reserves, why weren't they making new loans? The answer is that they began to be regulated differently in the U.S. by imposing binding capital asset ratios and periodic 'stress tests.' A bank that 'failed' a stress test (that did not have sufficient capital to absorb losses in a hypothetical Fed-designated 'crisis') might be denied making an acquisition or increases its dividend or even paying a dividend. So, when considering looking at the current situation through the same sort of monetary model, beware that the regulation of banks and 'control' or influence on the money supply was made to work differently. Central bankers everywhere are looking more at the adequacy of bank capital in making policy.

The table documents that money growth has been excessive globally and too strong for at least the last three years. The first chart documents how money growth bulged globally as Covid struck then 'slowed down' but did not back down to its pre-Covid pace. Money supply continued to run hot as recovery took hold and as GDP rates of growth surged back and as fiscal spending stepped up and then repeated itself. In the EMU, employment was largely maintained; in the U.S., the unemployment rate skyrocketed then plunged back down much faster than ever seen in any previous economic recovery.

It has been well documented that the Covid period supported incomes while people did not work. This meant that demand and income was supported while supply was reduced. To make matters worse, services were mostly damped or made verboten, driving relatively more demand to goods raising demand there and exacerbating supply shortages as supply chain issues emerged and worsened.

I like the supply side/excess demand/excess fiscal policy (too much income support) story better than the monetary story to explain inflation. But all these aspects were at work.

To be sure 'monetarists are going to go 'aha!' 'At last!' And those believers in what is called 'the modern monetary theory' are going to crawl off back under a rock somewhere. Print more money! Tra-la, Tra-la!

But it remains true that central bankers…after all of this… are unbowed…and are unrepentant. I am remined of a preacher in the John Huston film 'Wise Blood' who (no insult intended to anyone here…) represented the first church of 'Jesus without Christ,' “where the blind don't see, the lame don't walk and when you die…you're dead.” Well, that's a little harsh and not much to console the faithful, is it?

Yet, central banks tactics find ECB President Christine Lagarde saying no policy moves are planned or likely this year. In the U.S., the Fed is so non-plussed by 7% CPI inflation in 2021 that it is continuing to stimulate the economy and will only stop in March when it 'might' raise rates by one quarter of one percentage point.

Central bankers are too late taking away the punch bowl. The Fed is actually spiking it some more even as the police knock at the door and demand that they keep the racket down at their party! The Fed's response is wait 'til March… With a similar amount of neglect in place in 1979 G William Miller was pulled from the Fed and made Treasury Secretary (better fit there) and Paul Volcker was installed at the Fed. In 1979, Volcker introduced shock therapy to the financial markets - just one month after taking the job. At that time, the core CPI was up by 9.9% y/y and the headline was up 11.9%. Inflation had been running too hot for some time.

The road ahead
So, what does the future hold? Well, that is more complicated. The ECB plans to let the absence of new stimulus and high inflation do the work of slowing growth and damping inflation in addition to waiting for Covid disruptions to self-medicate- including supply chain problems. The once staid Fed in the U.S. has seen inflation jump too much to allow it to sit on its hands - now action in March is expected. Two or three (or more?) rate hikes are expected to come in 2022 alone. And then…?

The future is unclear. How the economies will respond to this aging recovery with less government assistance also is unclear. Will those disaffected Covid-scared workers come back to the work force? In the U.S., the Fed has given (now old) guidance in its dots but now 'the Street' is busy in game of one-ups-man-ship where everyone is trying to project more rate hikes that the next person. I'll see your four rate hikes and raise you one to five…

What is in prospect for rates?
In fact, I think this extended period of low rates that we have experienced will constrain central bank actions everywhere. Lagarde's statement on policy is clear. Powell's statement that this recovery is different will mean different things to different people. But while the ECB tries to see how long it can hold its hand over the flame of inflation without flinching, the Fed will be hiking rates…and I think it will be more measured than aggressive. The Fed is behind the curve; that's true. But that is spilled milk. Spilling more milk makes no sense. Powell wants to get the unemployment rate down; he said that will take a long recovery and that fact is inconsistent with ramming up rates or even gradually rising them too high. But it is also inconsistent with not controlling inflation. This lengthy period of low rates has made any dividend discount (or interest rate discount) method of asset valuation depend on very low rates. Small increases in rates are going to do more damage these days than many expect. What I think of here is the rate of return to corporations, stock valuations, house prices - any asset that is supported with any degree of leverage. Because this recovery is different. Hang on and see how central banks act when they must move but are walking on eggshells.

Commentaries are the opinions of the author and do not reflect the views of Haver Analytics.

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