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The writer is professor of finance at the Wharton School at the University of Pennsylvania
When oil prices fell to zero last May, few investors thought about inflation. But those studying the data on monetary conditions knew that the unprecedented buildup of liquidity would lead to an economic boom and higher prices as soon as vaccines ended the pandemic.
The monetary data is striking. Between March and November, the measure of broad money supply, M2, jumped 24%. Shockingly, the money supply surge in 2020 has surpassed any in the century and a half for which we have data.
Monetary expansion has also been robust across much of the rest of the world, but nowhere nearly as pronounced as in the United States. And the new Biden administration will surely provide even more fiscal stimulus.
One of the oldest propositions in economics is that the price level is determined by the demand and supply of money. The simplistic formulations of this proposition are called “The theory of quantities”. This proposition states that the rate of inflation is equal to the excess of the rate of growth of money over real income – although more sophisticated interpretations take into account other variables such as interest rates and expectations. inflationary.
But while many investors recognized that the huge increase in liquidity in 2020 was funneled into the stock market, few investors feared inflation. Most noted that the US Federal Reserve had embarked on a significant monetary expansion, known as quantitative easing, in the wake of the financial crisis. Despite warnings from many economists about rising consumer prices, inflation did not follow and in fact fell.
However, there was a fundamental difference between what happened during the financial crisis and what is happening now. The money the Fed created during the last financial crisis ended up in excess reserves in the banking system. A small part was loaned to the private sector.
This happened because prior to the Lehman collapse, the banks did not hold excess reserves. At that time, reserves earned no interest, and prudent reserve management required banks to maintain the absolute minimum to meet reserve requirements. All excess reserves were loaned on the money market.
The financial crisis has changed all that. Following the crisis, interest rates collapsed. The Fed has started paying interest on reserves, and regulators have imposed liquidity requirements that could be met with those reserves. The banks easily absorbed the additional reserves created by the Fed, and quantitative easing only led to a slight increase in lending.
But the actions of the Fed and the Treasury in response to the Covid-19 crisis produce a very different result. The money created by the Fed doesn’t just go into excess reserves in the banking system. It goes directly to personal and business bank accounts via the United States Paycheque Protection Program, stimulus checks and grants to state and local governments.
In the mid-1970s, I was a young assistant professor at the University of Chicago during the last years of Professor Milton Friedman’s distinguished career. I remember him telling me that aggressive reserve base expansion is a powerful force and would have saved us from the Great Depression of the 1930s. But if reserve expansion does reach savings accounts and control of the private sector, such action by the Fed is far more powerful.
These words informed my optimistic forecast last summer as the pandemic deepened. I said the United States is going to experience a strong stock market in 2020 and an extremely strong inflationary economy in 2021.
I certainly don’t expect hyperinflation, or even high single-digit inflation. But I think inflation will go way over Fed’s 2% target, and will do so for several years.
This is not good for bondholders. The huge demand for Treasuries, which has kept their yields so low, is driven by their strong short-term hedging characteristics – their ability to cushion sharp declines in risky assets.
But this insurance will become more and more expensive because the rise in consumer prices erodes the purchasing power of these bonds. It is inevitable that bond rates will go up and up much more than the Fed and most forecasters are currently considering.
The multibillion dollar war on Covid-19 has not been paid for by higher taxes or bond sales to the public. But there is no free lunch. It will be the holder of the T-bills, due to rising inflation, who will pay for the unprecedented fiscal and monetary stimulus of the past year.
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