Inflation In The 21st Century Is A Supply-Side Phenomenon

‘It is habitually assumed that whenever there is a greater amount of money in the country, or in existence, a rise of prices must necessarily follow. But this is by no means an inevitable consequence. In no commodity is it the quantity in existence, but the quantity offered for sale, that determines the value. Whatever may be the quantity of money in the country, only that part of it will affect prices, which goes into the market commodities, and is there actually exchanged against goods. Whatever increases the amount of this portion of the money in the country, tends to raise prices. But money hoarded does not act on prices. Money kept in reserve by individuals to meet contingencies which do not occur, does not act on prices. The money in the coffers of the Bank, or retained as a reserve by private bankers, does not act on prices until drawn out, nor even then unless drawn out to be expended in commodities.’

John Stuart Mill, Principles of Political Economy, Book III, Chapter VIII, par.17, p.20.

In his latest Global Strategy Weekly, Albert Edwards explains why he thinks the surge in the money supply is deflationary. As usual, he counters the consensus here, even though he gives credit to people like Russell Napier who correctly identifies the changing nature of US money supply but concludes that this is highly inflationary. I think Edwards is right for the wrong reasons, and Napier wrong for the right ones.

Edwards is right when he says that ‘despite massive stimulus, deflation will nimble on for a while yet until capacity constraints become binding further down the road’ (emphasis mine). Yet in his view, deflation will persist because cheap credit is keeping zombie companies alive. While I have no doubt that this is invariably true, its effect on the deflation-inflation dynamic is weak because credit creation is now a much smaller part of the money supply than in the past.

This is where Napier enters. He is right in his view that ‘politicians have gained control of money supply’ but wrong to believe that this will inevitably cause a rapid rise in inflation unless, indeed, capacity does become binding.

The reality is that money supply is now flipped on its head. While in the past, pre-2008, the delta of money supply consisted mostly of loans, after 2008 and during QE 1, 2 and 3, it moved to loans plus QE-generated deposits. During COVID-19, it shifted further away from loans by adding even government-generated deposits into the QE-time mix.

It is ironic that we had to go through QE, when the power of loan creation on money supply started to wane, for us to truly acknowledge their significance in the process of money creation in the first place. Loans create deposits – yes. But under QE, if the Fed buys from a non-bank, the proceeds go into a deposit at a bank without the corresponding increase in loans. If it buys from a bank, reserves at the Fed rise.

Source: FRB H.8

Things get more complicated when the government hands out free cash as this also goes on a deposit (government-generated deposits) with no corresponding loan creation.

Source: FRED, FRB H.8

Of those bank credits, actually, only about half are loans; the other half are securities. So, in fact, loans have created only about 1/6 of the money supply YTD (it would be even less if measured after the Fed/Treasury initiated their programs in March).

Source: FRB H.8

What about inflation? It’s difficult to see how this massive rise of money supply can produce any meaningful push in inflation given that the majority of that cash is simply being saved/invested in the market rather than consumed.

Moreover, this crisis is hitting the service sector much more than any past one. And unlike the manufacturing sector, which tends to be more cyclical, this decline in services may be structural, as the virus changes our consumer preferences in general (but also in light of the new social distancing requirements). Some of these services are never coming back. This is deflationary, or at a minimum it is dis-inflationary overall for the economy.

Services price inflation tends to be much higher than manufacturing price inflation. This paper from the ECB documents that this is a feature for both the EU and US economy and has been prevalent for the past 20 years.

However, as the paper demonstrates, the gap between the services and goods price inflation has been narrowing recently, starting with the 2008 crisis. I believe that after the COVID-19 crisis, the gap may even disappear completely.

For a sustained rise in inflation, we need a ‘permanent’ rise in free government handouts since that would increase the chance of some of it eventually hitting the real economy. The reality is that, even if this happens, the output gap is so big that inflation may take much longer to materialize than people expect. However, anything that shrinks the supply side of the economy (supply chains breakdown, regulations, natural disasters, social disorder, etc.) would have a much bigger and direct effect on inflation.

The bottom line is, as the speed of technological advances accelerates, and with no barriers to that, inflation in the 21^st century becomes much more a supply-side than a demand-side (monetary) phenomenon.