This article was written exclusively for Investing.com
We finally got some good inflation news last week. Money supply M2 declined in April from March, to the lowest rolling 3-month rate of change since 2018. Although the rolling 3-month average is turning around a bit – as I said, it was lower than that too recently than in 2018 – it is still much better news than when the figure hit 60% in 2020.
If we can continue to see monetary growth at 2%, inflation ultimately slow down once we reach the price level we are already stuck at. Not in 2022 or 2023, probably, but maybe beyond. Admittedly, it’s still too early to get excited about a 3-month change, but at least it’s in the right direction.
The Fed reported this data weekly, until early 2021. At that time, it decided to make the data monthly, with a lag. I can’t help but wonder if the 26% year-over-year growth rate at the time had anything to do with the decision, but the argument was that money growth doesn’t has no prognostic power, so why continue to place such an emphasis on it? After all, it was not as if this type of monetary growth was going to produce inflation, and moreover inflation was transitory, and caused by supply constraints, not something as plebeian as too much money for too few goods.
I mean really, who could have predicted that we would have? They should probably stop producing money supply data altogether. That will teach those stupid monetarists!
Comedian Lily Tomlin once said wryly, “No matter how cynical I am, I just can’t keep up.”
It just can’t be as simple as looking at money supply growth, and in fact it isn’t. The dynamics of the velocity of money are difficult to model accurately, although despite what people will tell you, velocity is not a random number and Milton Friedman never said it was constant.
But when money growth is 27%, you just don’t have to be very good at modeling velocity. The result was obvious. Although this is not so obvious to top-notch economists. Hats off to @MacroAlf for this Bloomberg chart:
The train came down the track, fast, whistling. Economists heard the whistle but obviously didn’t know what it meant. I would say “it will leave a mark”, but the cynic in me says that they will learn nothing from this series of colossal errors.
Take a step back…
As an aside, note in the chart above that forecasts always eventually converge to 2% or thereabouts. The incredible lack of imagination could be a sine qua non to get a job as a professional economist. The fact that current inflation readings are so completely off target might make a more humble forecaster wonder if inflation is not automatically reverting to the mean as the model says.
But this mean reversion is a very important part of modern macroeconomic inflation models; as I have already pointed out, it had to be so because of the survivor bias. From 1990 to 2020, any economic model that has not not the expected average inflation – return to a fixed level or slowly drifting target – has been ruled out. The entire universe of generally accepted models has been fed data from a period of low and stable inflation, and so only models predicting this outcome have survived.
Of course, to use a mean-reverting model, it is necessary to have a theory as to why inflation should mean-revert. The answer given was “anchored inflation expectations”. The flattening of the forecasts on the previous graph shows the influence of this supposed anchor. While blue chip economists are as indifferent to the drop in money supply growth as they were carefree about its peak, they are positively stunned by the 50-60 basis point pullback in inflation expectations. , at least as measured by TIPS break-even points. The chart below shows the 5-year inflation breakevens calculated by Bloomberg.
Now, personally, I don’t think inflation expectations matter as much as the blue-chip economics community does. I think it is likely that such an “anchor” lowers inflation volatility when the overall level is fairly low and stable since sellers would rather keep prices unchanged than draw attention to them by moving them all the time.
But when costs are rising rapidly and customers have 40% more cash than two years ago? I think “expectations” don’t matter in this scenario.
However, even if I thought expectations were important, I wouldn’t be very excited about this “lowering of expectations” for at least two reasons. First, we don’t have a good way to measure expectations. Surveys are bad for this because many cognitive biases operate in the realm of inflation – for example, people’s inflation expectations are unreasonably influenced by frequently purchased items like gasoline – and measures based on the market as the break-even points are polluted by the Fed’s actions in the bond market.
Second, and more important in this case, is that the decline in break-evens to date is almost entirely due to carry. If you think prices over the next 5 years are going to increase at a rate of 3.5%, then for three months they actually increase by 9%, then if your expectations for the level of futures prices have not not changed your “4.75- the break-even point of the year” will be much lower. So, looking at breakevens is an exceptionally bad way to look at expectations, when monthly inflation results are so important.
The fall in these “expectations” is in fact not significant at all. For years I have advocated an inflation futures contract that would allow us to see and trade the level of the futures price for a given date.
My company track where these futures would have trade, if they existed, based on current market inflation levels. It’s a way of seeing beyond the porting issue. The question that the future answers is: what futures price level am I waiting? The chart below shows our calculations for where December 2025 futures would trade, if there were any futures.
Source: Sustainable investments
The chart shows that expectations for the level of futures prices have risen in line with actual inflation seen for several years. Recently, expectations regarding the level of futures prices have ceased to be worse but they don’t improve either.
If expectations stabilize, they stabilize at a high level. Viscerally, that’s what I seem to hear from people, but I’m aware of selection bias (if you’re the inflation guy, more people complain about inflation). “Optimistic” on inflation, at this point, is not the same as expecting a return to 2%. Optimistic is a 4% return.
Michael Ashton, sometimes known as The Inflation Guy, is the Managing Director of Sustainable Investments, LLC. He is a pioneer of inflation markets with a specialty in defending wealth against the onslaught of economic inflation, which he discusses on his Podcast Cents and Sensitivity.