2022 Market Strategy: Deflating the Fears of Longer-Term Inflation
October 20, 2021 – Federal Reserve in Focus Again this Week with the November FOMC Meeting
The Federal Reserve Open Market Committee has just wrapped up their November meeting and has made the asset purchase ‘taper’ official. There are 2 broad-based guideposts to keep in mind as investors and the Federal Reserve alike prepare for the 2022 market strategy.
2022 Market Strategy Guidepost #1 – Never Forget the Definition of a Fed Asset Purchase ‘Taper’
Many investors panic at the thought of an asset purchase taper as if the Federal Reserve is somehow removing the backstop from the U.S. economy. This couldn’t be further from the truth, and Fed Chair Jerome Powell did a nice job reassuring investors that the Federal Reserve will maintain a monitoring stance and adjust the taper as necessary based on the progress of the economy. We would go one step further at Synergy and state that the asset purchase ‘taper’ is NOT shrinking the Fed balance sheet, rather, it is simply purchasing assets at a slower rate. Stated differently, the Fed balance sheet is still growing, and this remains stimulative albeit at a slower rate.
2022 Market Strategy Guidepost #2 – Think of Inflation Going Forward as a Balance of “Supply Push” and “Demand Pull”
While the inflation argument to date, remains focused on ‘Cost Push’ supply chain issues, Synergy has identified a material economic phenomenon that is tempering the ‘Demand Pull’ side of the inflation argument keeping longer-term inflation risks in check for the time being. Despite the M2 Money Supply more than doubling since the start of the Great Recession, inflation has remained muted because the turnover in the money supply has declined commensurate with the increase in the money supply. The velocity of M2 Money Supply is the rate of turnover in the money supply meaning the number of times one dollar is used to purchase final goods and services included in U.S. GDP.
Consumer Inflation (CPI) Increased 5.4% in September 2021 – Mainly “Cost Push” Supply Chain Driven Inflation at this Time
Consumer inflation, as measured by the Consumer Price Index (CPI) has increased 5.4% over the same, year ago, timeframe. The fear is that inflation tips us into a recession just as inflation is a precursor to most recessions in U.S. history. You must note that recessions tend to be driven by the Fed response to inflation in terms of an overshoot on tightening versus being caused by the inflation itself. These are the highest year-over-year increases in inflation we have seen in over 30-years.
Consumer Inflation (PCE) Increased 4.4% in September 2021 – Mainly “Cost Push” Supply Chain Driven Inflation at this Time
Consumer inflation, as measured by the Personal Consumption Expenditures (PCE) has increased 4.4% over September 2021. These are also the highest year-over-year increases we have seen in over 30-years and confirm the CPI read.
Consumer Inflation – Consumer Price Index (CPI) vs. Personal Consumption Expenditures (PCE)
Note when we overlay the CPI and PCE reads, both are at 30-year relative high levels. Even the large difference between the 2 series has been a precursor to 5 of the last 8 recessions. Again, the fear is that perhaps history is repeating itself. We at Synergy do not think this is the case, despite the media claims of demand for goods and services at all-time highs, the Velocity of the M2 Money Supply is simply NOT confirming this claim.
Parabolic Increase in M2 Money Supply – Is Increase Fueling “Demand Pull” Driven Inflation?
Trillions in Post-Great Recession stimulus across numerous QE cycles and Covid aid packages –
M2 is a broad measure of the monetary base and includes M1 – which is comprised of cash outside of the private banking system plus current account deposits – while also including capital in savings accounts, money market accounts and retail mutual funds, and time deposits of under $100,000.
Real M2 Money Supply – Monthly series seasonally adjusted and deflated by the CPI index.
Post-Great Recession Collapse in the Velocity of M2 is the Counter to the Increase in the M2 Money Supply
The velocity of the M2 Money Supply collapsed during Covid and has had 1 failed attempt at recovery and is currently trending in the wrong direction for inflation really take hold long-term. The velocity of M2 is the rate of turnover in the money supply meaning the number of times one dollar is used to purchase final goods and services included in U.S. GDP.
Velocity of M2 Money Supply Explains Lack of Post-Recession Inflation Despite Trillions in Stimulus Across Numerous QE Cycles and Covid Aid Packages
Since the Great Recession, the decline in Rate of Velocity of M2 has offset the increase in the M2 Money Supply such that inflation has remained in check. Analysts, economists, and forecasters have been proven wrong year after year and it is because of this chart.
Outside of Additional Government Spending, the Key Factors we Need to Monitor That Could Push Velocity of M2 Higher -Personal Savings Rate
A Personal Savings Rate decline like we saw in Pre-Great Recession levels, would trigger greater turnover in the money supply as this money would be potentially deployed into the economy and used to purchase goods and services thereby triggering an increase in the Velocity of M2 Money Supply. While personal savings rates have come down from Covid levels, they remain at a median Post-Great Recession trend level.
Outside of Additional Government Spending, the Key Factors we Need to Monitor That Could Push Velocity of M2 Higher -Consumer Loans
Consumer Loan Increase beyond current ‘median levels’ since the 1950s would trigger a greater turnover in the money supply as this money would be potentially deployed into the economy and used to purchase goods and services thereby triggering an increase in the Velocity of M2 Money Supply. Current levels of consumer loans are AT 70-year median trend and Post-Great Recession median trend despite record low-interest rates.
Outside of Additional Government Spending, the Key Factors we Need to Monitor That Could Push Velocity of M2 Higher -Commercial Loans
Commercial Loan Increase beyond current ‘sub median levels’ since the 1950s would trigger a greater turnover in the money supply as this money would be potentially deployed into the economy and used to purchase goods and services thereby triggering an increase in the Velocity of M2 Money Supply. Current levels of commercial loans are WELL BELOW both the 70-year median trend and Post-Great Recession median trend despite record low-interest rates.
In summary, for us to become fearful of inflation longer-term, we would need to see the velocity of M2 Money Supply gain steam and revert to more normalized levels. Outside of government spending, we would need to see banks lend at much higher levels than they are currently lending. We would need to see consumers and businesses alike spending at much higher levels than they are currently spending.
All are necessary just to get us back to ‘normalized’ levels of the velocity of M2 Money Supply of the 1.4 – 1.7 range. Until Velocity of M2 picks up steam and in the absence of a significant policy misstep from the Fed, we believe the inflation we are currently experiencing remains more a short-term, supply side, “cost-push” issue and will abate over time once the supply chain bottlenecks begin to unravel. For this reason, we believe that equity markets will continue to successfully climb the ‘wall of worry throughout 2022’ and we remain optimistic overall for the equity markets in 2022.
Right now, the largest risk we have beyond a Fed policy misstep is the inflationary expectation itself continuing to embed longer-term price and wage increases.
So, the sooner we can clear the supply chain bottlenecks, the better off we will be as price and wage pressures begin to subside. If we end up in a situation where supply chain induced, “cost-push” inflation remains elevated at the same time velocity of money induced “demand-pull” inflations heat up, the Fed will be forced to play its hand and respond with a policy that could risk tipping us into a recession if the long vs. short term inflation risks are not carefully managed.
Joe Maas, CIO | CFA, CFP®, ChFC, CLU®, MSFS, CVA, ABAR, CM&AA, CCIM
David Stryzewski, CEO | CSA, NSSA
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