M2 Spike Unlikely To Fuel CPI Inflation

Summary

• M2 has spiked but mainly with high-income households and nonfinancial corporations, which have a high propensity to save.
• This suggests limited impact on demand for goods and services and therefore on inflation.

Market Impact

• Long term – negative inflation hedges, e.g. TIPs, gold, commodities or crypto currencies.

Examining the Collapse in Money Velocity

The ongoing collapse in the velocity of money is unprecedented, especially as banks’ and, so far, borrowers’ balance sheets have remained strong (Chart 1). Rather, the decline in money velocity reflects a spike in risk aversion and precautionary savings and a collapse in credit demand. The households saving rate spiked to 34% in April, and at 14% in August remains well above the pre-pandemic level of about 7.5%. Simultaneously, bank loans not guaranteed by the government have fallen by about $900bn as borrowers have been repaying their debts, corporates have substituted market financing to bank lending,and banks have been tightening credit standards.

The Fed financial accounts show that households and nonfinancial corporations account for more than 75% of the M2 increase (Table 1). A detailed look at these sectors’ balance sheets suggests the M2 spike is unlikely to translate into a surge in spending when the economy normalizes.

Skewed Household Distribution of M2 Gains Suggests Limited Spending Impact

The household sector accounts for about half of the overall increase in M2. In addition, about 85% of the increase in households M2 has accrued to the top 40% of the income distribution. This suggests M2 balances are more likely to fund purchases of financial assets rather than purchases of goods and services because:

• Higher-income households on average have a much lower propensity to consume out of income than lower-income households (Chart 2). The same tends to apply to the propensity to consume out of wealth, especially out of financial assets.
• On average, the net worth of households in the top 40% of income distribution was down at mid-year, largely due to the large share of equities in their portfolios. This suggests that a recovery in equity markets could be necessary for even a small share of the increase in M2 to be spent.

Low-income households, on the other hand, are more likely to spend their M2 balances but have seen only a limited increase in them. Furthermore, the pandemic has disproportionately hit low-income households. Job losses have been largest in lowest-paid sectors such as leisure and hospitality, retail, and health and education. As a result, low-income households are more likely to be unemployed and therefore likely to spend their savings gradually until they find a new job.

Corporate Financial and Real Estate Investment Greater Than Productive Investment

The nonfinancial corporate sector accounts for about 25% of the overall increase in M2. Unlike households that have funded the increase in M2 balances through savings, nonfinancial corporations (NFCs) have funded them through borrowings. The establishment of the Fed corporate funding facility has facilitated these. The issuance has also funded real estate investments rather than productive investments (facilities, equipment, intellectual property products and inventories).

NFCs’ preference for holding the proceeds of their borrowings in M2 balances could reflect uncertainty on the future course of the epidemic and the need to builds cash buffers: relative to total assets, M2 balances are high. Once the economy normalizes, corporates could decide to spend their dry powder on productive investments.

However, since the great moderation of the 1990s, the share of financial assets and of real estate in corporate balance sheets has increased and that of productive investments decreased. This partly reflects a decline in real interest rates that has ‘juiced up’ returns on financial assets relative to returns on productive investments. The latter have been driven by the same mediocre demand growth that has allowed inflation and real interest rates to fall (Three Conditions for a Lasting Inflation Acceleration, 16 July 2020). The divergence between the returns on financial and on productive assets is shown for instance by faster growth in the SPX index than in earnings, a proxy for the returns on productive investments. And, of course, QE has further distorted the return on financial assets relative to those of productive investments.

Without a change in the current low inflation regime and the very dovish monetary stance, the combination of strong Fed support to markets and mediocre GDP growth is likely to continue. In turn, this could see further divergence between market returns and economic fundamentals. In such an instance, economic normalization could see only a limited share of NFC M2 balances spent on productive rather than financial or real estate investments.