At the recent Jackson Hole Economic Summit, Jerome Powell unveiled the Federal Reserve’s (Fed’s) new monetary policy designed to create inflation. In this article, we will discuss the 5-reasons why the Fed will not get inflation, and why deflation is the bigger risk.
The current assumption is that the Fed’s new policy will lead to higher inflation.
“The new policy regime is an important evolution in our thinking about how to achieve our goals and another step toward greater transparency, The policy change positions us for success in achieving our maximum employment and price stability goals in the future.” – Fed Reserve Bank of NY, John Williams, via WSJ
What exactly is this new policy? Well, that’s the interesting part, no one actually knows. However, as noted by the WSJ:e
“The Fed said it would now seek to hit its 2% inflation target on average, and that it wouldn’t raise rates just to ward off the theoretical threat of inflation posed by a strong job market. The Fed, however, didn’t say how it would determine the average, and several regional Fed officials suggested that a 2.5% jobless rate was as much as they would tolerate. At the same time, with the economy in deep trouble, there is little expectation inflation will test the Fed’s target for years.”
So, to be clear, the Fed’s new policy is simply to “average the inflation rate” over a period of time and let the unemployment rate fall to as low as 2.5%. The last time the unemployment rate was at 2.5% was for one quarter in 1953 just before the 1954 recession set in.
40-Years of Falling Inflation
The entire premise behind the Fed’s “new policy,” and by being extremely vague about it, is to allow the Fed to maintain, and engage in, “ultra-accommodative” policies without any real limits. However, as shown below, the Fed’s monetary policies have not been successful at creating stronger economic growth or inflationary pressures.
Furthermore, while Wall Street is “buzzing” with talk of surging inflation, the reality is such is not likely to be the case. As we discuss below, the Fed’s policies are actually “deflationary” in nature.
Why Printing Money Won’t Create Inflation
“The Fed is printing money like crazy which is going to lead to inflation.”
For the last 12-years, this belief has remained a constant in the market. It stems from the idea that increasing the money supply is inflationary as it decreases the value of the dollar. There is indeed truth in that statement when considered in isolation. However, when the money supply is increasing, without an increase in economic activity, it becomes deflationary.
The chart below compares the money supply to GDP growth and our composite economic indicator which is comprised of inflation, wages, and interest rates which all have a direct correlation to economic activity.
Importantly, since 1980 as the money supply increased, economic activity slowed.
This is where monetary velocity becomes important.
What the Fed has failed to grasp is that monetary policy is “deflationary” when “debt” is required to fund it.
How do we know this? Monetary velocity tells the story.
What is “monetary velocity?”
“The velocity of money is important for measuring the rate at which money in circulation is used for purchasing goods and services. Velocity is useful in gauging the health and vitality of the economy. High money velocity is usually associated with a healthy, expanding economy. Low money velocity is usually associated with recessions and contractions.” – Investopedia
With each monetary policy intervention, the velocity of money has slowed along with the breadth and strength of economic activity.
However, it isn’t just the expansion of the Fed’s balance sheet which is undermining the strength of the economy. It is also the ongoing suppression of interest rates to try and stimulate economic activity.
In 2000, the Fed “crossed the Rubicon,” whereby lowering interest rates did not stimulate economic activity. Instead, the “debt burden” detracted from it.
To illustrate the last point, we can compare monetary velocity to the deficit.
To no surprise, monetary velocity increases when the deficit reverses to a surplus. Such allows revenues to move into productive investments rather than debt service.
The problem for the Fed is the misunderstanding of the derivation of organic economic inflation.
Why Inflating Asset Prices Won’t Create Inflation
The one thing the Fed has done very successfully is to create “boom and bust” cycles within the economy which has continued to erode the economic prosperity of the masses.
The only reason Central Bank liquidity “seems” to be a success is when viewed through the lens of the stock market. Through the end of the Q2-2020, using quarterly data, the stock market has returned almost 135% from the 2007 peak. Such is more than 12x the growth in GDP and 3.6x the increase in corporate revenue. (I have used SALES growth in the chart below as it is what happens at the top line of income statements and is not AS subject to manipulation.)
Unfortunately, the “wealth effect” impact has only benefited a relatively small percentage of the overall economy. Currently, the Top 10% of income earners own nearly 87% of the stock market. The rest are just struggling to make ends meet.