It has been a long time since we have seen a rise in the inflation rate of any magnitude. As a result, most investors have largely dismissed inflation as a near-term concern. But that doesn't mean we have vanquished this troublesome variable from the financial equation forever.
There is a reason that inflation fears have subsided. Ever since the Financial Crisis, when central banks and governments dumped trillions of dollars into the world's economies, investors feared that all this money would re-ignite the inflation fire. It didn't happen. Instead, the inflation rate moderated, and in some countries began to drop. Rather than worry about inflation, investors and central bankers began to worry about the opposite — deflation.
You see, inflation, as any economists will tell you, is caused by an increase in the velocity of money. Simply put, velocity is a measurement of the rate that money is exchanged. It is the number of times that money moves from one entity to another.
Let's say I borrow $100 from my local bank. I spend $10 of it at McDonald's, another $20 at the movies, and spend the rest taking my wife out to dinner. If any of these three use that money to pay their suppliers, workers, or whatever, the money I spent is passed on to others. If they, in turn, take that money and buy items of their own with it, then the velocity of money continues higher. Over time, if this continues, the velocity of that same $100 will be so great that too much of this money will be chasing too few goods. In which case, inflation takes off.
One of the principles of economic theory is that in order for inflation to catch hold, all the money that central banks dumped into the global economic system over the last decade had to somehow find its way into the hands of consumers, who will spend it and pass it on. That didn't happen either. Instead, the world's banks and other financial institutions, stashed all that central bank cash in their electronic vaults, but didn't lend it out. There were two reasons for this.
The first one was fear. Banks were not about to lend this money to consumers, or corporations, given the aftermath of the crisis. Lending (in the form of mortgage money), was a big risk for banks, given what happened to the housing markets during 2008-2009. At the same time, unless you were one of the bluest of blue-chip companies, banks were charging an arm and a leg for corporate borrowers. Besides, the corporate appetite to borrow money was tepid at best. Given that the economy was sluggish, and the future uncertain, who really wanted to invest?
The growth rate of the economy continued to justify that attitude. The economy remained anemic throughout the Obama years and beyond. Companies argued that there just wasn't enough incentive to invest. Taxes were too high and regulations too onerous.
The Trump administration, as we know, thought they had provided the solution. They cut regulations and gave businesses a massive tax cut, expecting that at long last corporations would hire workers, raise wages, and grow the economy. Instead, all companies did was buy back their stock, pay out larger dividends, or acquire other companies with the money. The only inflation we experienced was in the stock market as prices of financial assets soared.
Fast-forward to today, worldwide, both governments and their central banks have upped the ante on additional monetary and fiscal stimulus, thanks to the pandemic. They feel they can do so with impunity, knowing consumers worldwide will not be spending much of that money until the all-clear is sounded on the pandemic side. They are confident that despite the fact that while monetary and fiscal stimulus is at historical highs and still growing, inflation will remain subdued.
As long as all that new stimulus money remains in the banks and does not fall into the hands of the consumer or into business investment, the velocity of money should remain tame. However, in my next column, I will point out that in this new round of stimulus, the Federal Reserve Bank has changed the rules of the game dramatically.
At the same time, more and more politicians, and some economists, are arguing that Modern Monetary Theory (MMT), by necessity, should be the natural direction the world takes in combating the fallout from the pandemic. Why is that important?
I believe by force of circumstances, both the Fed and proponents of MMT may be rubbing a lamp that could lead over time to releasing that genie of inflation back into the world once again. I'll explain why in my next column.
Bill Schmick is now the 'Retired Investor.' After working in the financial services business for more than 40 years, Bill is paring back and focusing exclusively on writing about the financial markets, the needs of retired investors like himself, and how to make your last 30 years of your life your absolute best. You can reach him at email@example.com or leave a message at 413-347-2401.
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