No Inflation in Sight! Why? Understanding money and interest rates beyond sound bites!

Investors and policymakers around the world are mystified by the current macro financial context: very low unemployment and no inflation. This causes many to think interest rates are about to spike OR that the Phillips Curve is dead OR that we need to measure it another way. Here are some reminders about inflation, interest rates, and financial markets that every investor needs to know.

Money, inflation, and interest rates

Money is created when debt expands. The debt expansion can come from the government OR households OR corporations (or all 3!), but you need new loans to create new money, and you need new money for inflation to rise.

You can also get inflation via a depreciation of the currency, because the weaker currency makes imports more expensive, which adds inflationary pressure to the economy, a phenomenon called “import push inflation”, as observed in the UK, with the pound having depreciated 10% over the year following Brexit.

This is the first thing many forget: there is a difference between “base money” and effective money supply. In short, effective money supply “Ms” is base money multiplied by the “money multiplier” Ms = m*BM. The money multiplier is influenced by the desire by banks to hold reserves and the desire and willingness of the economy to take on debt, and a few other factors.

Right before the Great Depression, in 1929, the general public held about 18% of money holdings in cash, while banks had reserves less than 1%. In 1933, these same ratios rose to 35% and 5% respectively. Base money barely changed, yet the effective money supply crashed, because the money multiplier contracted by roughly 40%. Deflation became widespread and nominal amounts on debt became harder to service, while wages became too expensive to pay in the face of crashing prices and profits, thus causing massive unemployment.

So. In short: more credit = more money = more inflation.

How does money create inflation?

Suppose I give all citizens of the country 1 million dollars today. What happens? In the short run, there is magic: everyone is now a millionnaire! Since prices have not yet adjusted, we will all buy a 2nd and 3rd house, car, TV, we will travel more and go more to the restaurant, etc. At one point, this strong demand needs to be produced (supplied), and that requires more workers, more machinery, more real estate, etc. The economy will hit limits to production and the extra demand will be frustrated by the lack of supply… unemployment will fall to zero, firms will increase prices, wages will rise due to the scarcity of labor, and expectations about future inflation will start to adjust upward, which will cause more inflation and depreciation of the currency… the crashing currency will cause imports to be more expensive, adding to inflation, etc. In the end, all transactions will have more zeros and nothing special in terms of real purchasing power will happen.

Why inflation is low in the USA now

Below is total non-financial debt as percent of GDP. It is very flat relative to the pre-2008 period. The slope is a proxy for money expansion and future inflation… There simply is no possibility for significant inflation with this credit structure.

Here is government debt-to-GDP:

Note that government expenditures in the USA is roughly 34% OF GDP. The State is not piling on extra debt at a fast pace, hence there is also low inflation potential coming from there.

Since a country can also get inflation due to a depreciating currency via the increase of the price of imports, you must also look at the ratio imports-to-GDP to get an idea of this effect. The higher the ratio, the stronger the “import push inflation” effect will be.

US IM-to-GDP ratio is about 15%, which is low, so there is limited scope for import push inflation via depreciation…

Central banks are pushing on a string

The Fed, the BOJ, the ECB and even the BOC are all searching for elusive inflation, but are finding it hard to create. It is significantly easier to decrease inflation when it is high than to increase inflation when it is low. In other words, the Phillips curve is not linear.

Negative interest rates are used to “penalize” the accumulation of bank reserves so that those reserves are instead transformed into loans and inflation down the road, but banks are instead parking their cash in federal bonds. Add to this aging populations seeking to save for retirement and you get weak credit expansion, hence low inflation.

Central banks are trying to boost inflation, but they are “pushing on a string” because the banking credit creation process is stifled by demographics, sluggish business investment, and limited scope for government expenditures financed by money creation.

What to do? The only thing that would convincingly create inflation would be to GIVE lots of money to households. How? The government would send money to people and would finance it with central bank money, effectively selling massive quantities of federal bonds to the central bank and using that money to send cheques to people. This is not on the verge of happening, so don’t expect a cheque anytime soon.

Consequences

This means monetary tightening has limited scope in most industrialized economies as long as central banks remain fixated on some inflation target. This in turn means that markets will typically expect more tightening than will happen in all cases. It started with the USA: the USD appreciated and then deflated as markets came to grips with what I am explaining now… The same will happen to the Canadian Dollar, which I have been bullish on ever since the BOC changed tone in June (and I mentioned this in my posts way back!)… The monetary tightening will not go far and the CAD could end up a bit over-appreciated, especially if markets continue on their n=bullish CAD bias for a while (as signalled by the COT Report).

All this means there is scope for further stock expansion in many countries (barring shocks like war, terrorist attacks, Eurozone stress from from weak members (especially Italy), or political drama becoming a serious issue in the USA or the Eurozone). There is risk for asset bubbles and excessive leverage and risk appetite caused by extended periods of low interest rates in low inflation contexts.

There is also potential for confusion, as markets tend to think in overly simplistic terms, refusing to look in the details and then wondering what is going on with interest rates and stock markets… but as the saying goes: the devil is in the details. Like and share!

Pascal Bedard

pbedard@yourpersonaleconomist.com