“Only a crisis, actual or perceived, produces real change”
– Milton Freidman
Will one of the consequences of the Covid-19 crisis be a return to the inflationary era of the 1970s? Sometimes we take the consequences of evolution for granted. In the 1930s, during the Great Depression, many questioned the sustainability of capitalism as the social and economic foundation of our society. The economic devastation the global economy experienced in the first four decades of the 20th century, led to the rise of populism and the desire of many to seek an alternative economic system; socialism, communism, and even fascism were models that many countries turned to. The recent rise of populism suggests the world’s western economies are again questioning the foundations of their societies.
With the public policy response to Covid-19 being to shut down the global economy, the response from central bankers has been swift and unprecedented in magnitude. This response, with ample potential to be increased further, as noted in the chart below, could create intense future inflationary pressures.
Investors need to prepare now for rapidly rising inflation and interest rates that could affect them in the not too distant future. The result of random events such as Covid-19 is that it propels trends forward, compressing years of evolution. As Nassim Taleb suggests “History and societies do not crawl. They make jumps”, as we are currently experiencing the jump to a fully digital economy with the potential for strong inflationary pressures.
The policy mistakes in 1929, the contraction of the money supply and trade isolation, gave rise to widespread support for Keynesian economics. In the mid-1930s, economists from the University of Chicago countered with Adam Smith’s, The Wealth of Nations, to help re-anchor the United States to capitalist economic theory. The concepts that a rational man would make decisions out of self-interest to maximize his well-being, and that millions of rational consumers and free markets were the most efficient way to allocate resources through changes in price (the invisible hand), were the foundations of modern economics.
A long list of Nobel Prize winning economists came from the University of Chicago, none more famous than Milton Friedman, the father of monetarism, a macroeconomic concept which states that the supply of money is the most important driver of economic growth, and that excessive monetary expansion is inherently inflationary. Milton Freidman proclaims that “inflation is always and everywhere a monetary phenomenon that arises from a more rapid expansion in the quantity of money than in total output”. Freidman also theorized that “only a crisis, actual or perceived, produces real change”.
To wit, we may be ushering in a new era of inflation, with significant growth in the supply of money as highlighted in the chart below.
The response from politicians and public health officials to the Covid-19 pandemic was to shut down the global economy. The response from central bankers in conjunction with treasury or finance ministry officials was to inject the economy with levels of capital and liquidity never seen before to keep the economic patient alive. The moves were bold. In the United States, the coordinated program between the Federal Reserve (the Fed) and the treasury department has the potential to inject more than $6 trillion into an economy of approximately $22 trillion. In-turn increasing the fiscal deficit from 4.7% of GDP, to potentially over 20%. Money supply (M2) growth is already over 20%. The Bank of Canada has already tripled the size of its balance sheet. In a world defined by Milton Friedman, these actions will lead to inflation.
What may come as a surprise for many investors is that Chairman Powell, along with other global central bankers, signaled in 2019 a desire to abandon the playbook developed by Paul Volker in the 1970s, and to generate inflation above the 2%. To wit, the Fed may not be in a hurry to raise interest rates and reduce its balance sheet once the economy opens. Chairman Powell said as much in his most recent Q&A session, frequently anchoring expectations for the medium-term, not the short term. To be sure, with the Fed’s favorite measure of inflation, the 5 year forward inflation expectation (chart below) being well below 2%, they will be in no hurry to take the punch bowl away.
Market participants are falling into two distinct groups. One still fears a retest of the March lows, and has continued to de-risk their portfolios, contributing to almost $5 trillion sitting in money market funds. The other group is unwilling to fight the Fed and recognizes that shock events typically speed up evolution and innovation.
The second group is already positioning their portfolios for late 2021 which is when inflationary forces are anticipated to become too strong to ignore. Increasing the money supply by itself however will not create excessive inflation. What is also needed is for the “velocity” of money, the number of times that an average unit of currency is used to purchase goods and services within a given period, to accelerate. On that front we look to current banking policy contrasted with what occurred during the financial crises.
As investors, we are constantly trying to separate the signal from the noise. One policy change that some investors may have missed in all the noise, is the fact that banking officials in Canada and the United States have reduced the required reserve ratio for banks. In a fractional banking system, the reduction of the required reserve should, in theory, increase the money multiplier which should lead to higher inflation. Banks, in theory, will be able to make more loans if the demand is there.
The crisis of 2008 was a banking crisis. When policymakers injected the economy with liquidity, they also implemented policies that would restrict the creation of credit. Today, during this public health crisis, extreme levels of capital have been added to the global economy, and reserve ratios have also been relaxed. In theory, as the economy grows, and demand for credit comes back, inflation should also return. Will the change in the required reserve ratio be a permanent policy change? It is too early to tell. To be sure, a permanent change could cause many investors to rethink their investment thesis on banks. Could they be re-rated as growth stocks? Will Gold and Bitcoin come back into vogue as inflation hedges? Only time will tell. As Friedrich Nietzsche suggests “there are no facts, only interpretations”, with the growth in money supply at extreme levels, and with the implementation of policy allowing banks to create more credit, a period of inflation in late 2021 should be seriously considered by investors.
It is hard in this 24-hour news cycle to separate the signal from the noise. But for those who see the potential to accelerate the move to a new digital economy combined with policy measures taken to support the economy through this crisis, a period of strong inflationary pressure would be a reasonable consequence.
It will be hard for many investors to conceive allocating capital today into assets that outperform in an inflationary market. Investors with longer time horizons however are beginning to position their portfolios for this eventuality, by developing a barbell approach, focusing on the new post-Covid-19 digital economy while at the same time focusing on investment opportunities that benefit from a rising interest rate inflationary environment. Hardly a return to the 1970s, but yes, definitely a major jump for investors to process.