by Asset Allocation Committee | PDF

One of the burning issues about the current path of policy is its inflationary impact.  In other words, will the massive increase in fiscal spending and the Fed’s balance sheet lead to higher price levels?  To discuss this issue, we return to the equation of exchange:

M x V = P x Q

The money supply times velocity is equal to the price level times goods and services produced.  This equation is an identity; simply put, it will always be true.  But, the direction of causality of the variables comes from theory.  Classical economists and their philosophic progeny, monetarists, argued that V and Q were fixed, so changes in price levels were due to changes in money supply.  Keynesians and their most recent variation, modern monetary theorists, argue that Q can be below its capacity and V is variable, so increases in M may not necessarily lead to higher price levels but could result in a decline in V or a rise in Q.  Essentially, the Keynesians and their modern versions argue that if Q is below capacity, increasing M can boost the economy without triggering inflation.

The problem with both of the major theories is that there is a psychological element to the equation that tends to be downplayed.  The problem for the Classical construct is that even at full employment (Q) rising M might simply lead to falling V.  Complacency about future inflation or fears about the future growth path of the economy might lead households and businesses to simply hold larger cash balances.  Confounding the Keynesians is the potential outcome where P rises even with Q below capacity when M is increased if economic actors fear future inflation.  In fact, higher price levels can result even without a rise in M if V rises.  The most extreme case of this condition is hyperinflation, where V rises rapidly as households and businesses rush to convert cash to real goods that will hold their value.

Therefore, determining if there is an inflation problem from current policy is tricky because there is a psychological element that is difficult to estimate.  It is easy to measure money supply, output or price levels, but the psychology of velocity is hard to measure and potentially prone to sudden shifts.

Reframing the question can simplify this problem.  If a household receives a notable sum of money, let’s say, $10,000, what does it do with it?  If the householder fears future price increases, it would make sense to use that money to buy inventory.  In other words, they may take part of it to buy food, perhaps consumer durables, art, gold, or other items that might hold their value.  On the other hand, if there is little fear of future inflation, the household may be content to simply hold the cash as savings or place it in other financial assets.

One way to answer this question is to compare the money supply to gold prices.  If some money supply, say, M², rises faster than gold, it would suggest that economic actors are not afraid of future inflation.  A rising ratio of M²/gold would be a positive signal for financial assets; on the other hand, a falling ratio would likely be bearish.  Now, it is possible that a contracting money supply could distort the measure.  The monthly change in M² since 1959 has only been negative 4.4% of the time.  Over that same time frame, it has never been negative on a yearly change basis.

Anyone familiar with financial market history can note that equity markets tend to outperform when this ratio rises, but equities tend to suffer when the ratio declines.  The ratio captures that when the supply of money is rising relative to gold (the proxy for real assets), economic actors tend to put this excess liquidity into financial assets.  A declining ratio suggests a preference for real assets.

In general, the ratio has been mostly steady for the past four years.  Despite a rally in gold, the ratio hasn’t declined.  Put another way, we haven’t seen households and firms show significant inflation fears despite a massive increase in liquidity.  Gold prices have been mostly rising with M² but not accelerating faster than the money supply.  And so, in a portfolio, gold has been acting as a diversification asset without unduly hampering performance.  As the Fed has boosted liquidity, funds have been going into both stocks and gold at a pace where neither has signaled a particular bias.  If inflation fears escalate, we would expect this ratio to decline and equity markets to show signs of weakness.  But, for now, easy monetary policy is supportive for both gold and equities.

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by Asset Allocation Committee

Equity markets, to a greater or lesser degree, tend to reflect social and political trends.  After all, the mood of investors plays a role in the propensity to move money into stock markets.  Unfortunately, the impact of social or political events on equities tends to be a mixed bag.  The chart below shows over 120 incidents from 1896; some events were notable, while others had only a modest impact.

What is notable about this chart is that some factors can be bullish, such as the creation of the assembly line or the introduction of the internet.  Some events would seem to be negative, but the impact is fleeting, whereas other negative occurrences have a much more significant impact.

The U.S. is experiencing a wave of civil rights protests similar to what occurred in 1968 (#73 on the above chart).  On its face, civil unrest would seem to be a negative factor for investor confidence.  However, at least initially, the widespread protests may lead to a policy response that is supportive for equity prices.

One of the effects of the 1968 civil unrest was the Humphrey/Hawkins Full Employment Act.  The law required policymakers to strive for full employment.  In fact, the bill had four policy goals—full employment, a balanced fiscal budget, a balanced trade account and price stability.  As anyone with a modicum of formal economic training can note, these four goals are not necessarily consistent.  In other words, achieving full employment and price stability or a balanced budget may not be possible.  Therefore, policymakers had to decide which goal was preeminent.  The bill was passed in 1978; by the time it was enacted, concerns about full employment had been supplanted by inflation worries so the bill never really lived up to its sponsors’ goal of full employment.  However, it is this bill that requires the Fed chair to semiannually travel to Capitol Hill to talk about monetary policy and the economy.

Forty-two years after the passage of Humphrey/Hawkins, there is growing evidence that the Federal Reserve is focusing on employment, especially minority employment.  Spearheading the effort is Atlanta FRB President Bostic, who recently penned a letter on racism.  But, beyond what the Federal Reserve system can do with its own hiring and its regulatory power over lending, there is a question about what monetary policy can do about this issue.  After all, setting interest rates is a blunt policy instrument.  In his recent press conference, Chair Powell noted that minority unemployment had declined markedly before the pandemic, but has risen since the recession occurred.  In his opinion, the best way to boost minority employment is to foster a strong labor market.

This chart shows the unemployment rate for African Americans and Caucasians.  The rate for the former is persistently above the latter, but what is notable is that the longer an expansion lasts the narrower the difference between the two series becomes.  If the Fed is serious about reducing African American unemployment, one of the important policy goals would be to extend the expansion as long as possible.

To some extent, this is nothing new; monetary policy isn’t designed to end an expansion prematurely.  But, this information signals to investors that the Fed has yet another reason to preserve an expansion, which is supportive for equities—unless it becomes apparent, at some point in the future, that the FOMC would be willing to allow inflation to rise above target to preserve the expansion.  In general, for the past 33 years, major declines in equity markets have been tied to recessions.  That is true, in part, because the Federal Reserve has earned inflation-fighting credibility.  It remains to be seen whether what we are observing now represents a more notable shift away from inflation suppression.

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