Is Inflation Finally On The Horizon?

After more than a decade of below-average inflation rates in the U.S., there’s a basic question that begs answering: Is inflation on the way? This same question was asked quite a bit coming out of the Great Recession (2008-09), and there was much fear that higher inflation would ravage the U.S. economy. That fear wasn’t misguided, as the historical relationship between inflation rates and money supply has been highly correlated in decades past.

Is this time different? Often regarded as the four most dangerous words in the English language, trying to determine whether this time truly is different, particularly when it comes to inflation expectations, could prove once again to be an exercise in futility. Regardless, Americans should enter with eyes wide open into this next phase of economic recovery (or malaise). Doing so is highly recommended, given the monetary stimulus that had been so quickly injected into the U.S. (and global) economy to help stabilize several challenged aspects of pandemic crisis management: unemployment benefits, small-business survival, municipal and corporate lending facilities, and Federal Open Market Committee (FOMC) activities.

In its simplest form, I’ve always looked at money through the lens of being just like any other product in a marketplace. As such, it’s subject to the laws of supply and demand. Here’s a little Economics 101 review: When a product becomes scarce and demand for it remains stable, then its price naturally rises in the marketplace. Likewise, when demand falls and supply remains unchanged, its price settles lower. Stock markets, bond markets and banana markets all succumb to this same marketplace dynamic. So, what happens when supply increases with falling demand? Although it’s hard to imagine this scenario for goods or services—a company increasing its supply into a marketplace with less demand—the endgame is the same. Market dynamics would force the price to a much lower market price equilibrium.

This last example is what we can apply to the money “market.” Flooding the marketplace with money (e.g., Federal Reserve monetary stimulus) results in increased money supply. Assuming stable demand for money, the effect of increased supply would drive the value of the money down, along with the interest rates associated with that money (or currency). However, let’s say that the demand for money doesn’t remain stable, but drops and stays lower for longer (e.g., GDP growth). From Q3 2017 to Q2 2020, U.S. money supply grew from $13.6 trillion to $16.5 trillion (a 21.3% increase), while U.S. real GDP fell from $18.2 trillion to $17.2 trillion (a 5.5% decrease).

The dynamics of greater money supply versus lower goods/services production has the net effect of more money chasing fewer goods/services. This manifests with price inflation of those goods/services, until such time that either money supply is mopped up through FOMC activities or, more likely, higher output (driven by consumption) within the economy occurs. How long does all this take? Will this time be different? Ultimately, these are difficult predictions to make with a high degree of confidence, but their implications are worth noting for anyone living off fixed income or planning for retirement income over the next decade or two.