Post from First Trust Economics Blog

Brian S. Wesbury – Chief Economist
Robert Stein, CFA – Deputy Chief Economist 

Sept 20th, 2021

Some analysts and investors breathed a big sigh of relief

on inflation when it was reported last week that the Consumer

Price Index rose 0.3% in August versus a consensus expected

0.4%. But we think any sense of relief is premature.

First, in no way, shape, or form, is a 0.3% increase in

consumer prices indicative of low inflation. Consumer prices

rose at a 3.3% annual rate in August, which is still well above

the Federal Reserve’s 2.0% target. Yes, we are well aware

that the official Fed inflation target is for the change in the

PCE deflator, which always runs a little lower than the

increase in the CPI, but it doesn’t run anywhere close to 1.3

points lower, which is what it’d have to do for the Fed to hit

the long-run 2.0% inflation target.

Second, a number of sectors had price declines in August

that should not persist. For example, airline fares fell 9.1% in

August and are now 17.4% below the average fares of 2019,

which was pre-COVID. So, as COVID gradually recedes

these prices should rise.

Third, housing rents are likely to accelerate sharply in

the years ahead, including for both actual tenants as well as

owners’ equivalent rent, which is the rental value of homes

occupied by homeowners. With the eviction moratorium in

place, rents have grown unusually slowly for the past eighteen

months. But, going back to the 1980s, rents tend to lag the

Case-Shiller home price index by about two years. Now, with

the national eviction moratorium finished, look for rents to

make up for lost time. And because rents make up more than

30% of the overall CPI, anyone predicting lower inflation

numbers in the future are saying other prices will fall.

Ultimately, however, it’s important to recognize that

inflation is still a monetary phenomenon and the M2 measure

of the money supply is up about 33% since February 2020,

pre-COVID. Eventually, that will translate into a substantial

rise in overall spending or nominal GDP (real GDP growth

plus inflation) and since the Fed has little to no control over

real GDP growth beyond the short-term, that means higher

inflation.

One way to think about it is that between the late 1950s

and early 1990s, the ratio of nominal GDP to M2 hovered in

a narrow range very close to 1.8. What that means is that

every new dollar of M2 translated into 1.8 more dollars of

spending. And if the ratio remains the same, then a 10%

increase in M2 leads to a 10% increase in overall (nominal)

spending.

This ratio rose in the 1990s. Interestingly, so did real

GDP growth. So, the strong real growth of the 1990s was

actually associated with lower inflation. Since then, the ratio

of GDP to M2 has generally dropped. Immediately prior to

COVID, in the last quarter of 2019, the ratio was 1.42; now

it’s 1.12. What this has meant is that M2 growth has not

translated directly to inflation.

However, let’s assume the ratio is headed back to the

1.42 that prevailed just before COVID. If nominal GDP

normally grows 4% per year – 2% real GDP growth plus 2%

inflation – it would take six years (so, 2027) to get back to that

1.42 ratio. But that’s only if M2 doesn’t grow in the interim.

No change at all. More likely, M2 does grow in the interim

and that additional growth feeds through directly to higher

inflation.

Another way to think about it is that the ratio of nominal

GDP to M2 has dropped because the velocity of money has

fallen. That’s the speed with which money circulates through

the economy. It’s hard to see velocity falling further from

1.12 because to do so means eventually going below 1, and

that has not happened in any recorded history of the US.

The Fed meets this week and will be issuing its usual

statement after the meeting. We don’t anticipate any

significant changes to monetary policy at this meeting,

although we do expect a hint that the Fed will announce a

tapering of quantitative easing to begin after the next meeting

in early November.

However, the Fed will also be releasing a new set of

economic projections as well as projections about the path of

short-term interest rates. Back in June, the Fed was

forecasting that inflation would be back down to roughly 2.0%

in 2022. If they make a similar forecast this week, it will be a

sign that it isn’t taking upward inflation risk nearly as

seriously as it should.