A Return of that Other Bubble?

I was working on Wall Street during the crash of October 19, 1987, when the Dow dropped 22% (or about 7,000 points in today’s market). That evening, traders gathered at Harry’s Bar to commiserate. One of the old timers pulled me aside and said, “You know why this happened? It is because everyone that lived through ‘29, is either dead or retired.” So it goes with the mercurial short-term memory of the financial markets.

People are starting to talk about inflation again. Now, I am the old-timer (sort of), and I wonder if anyone remembers the great inflation of the ‘70s and early ‘80s? What is it like living with high inflation?

In 1981, I finished a nine-month training program at Chase Manhattan Bank and I got the standard raise of 26%. I bought a co-op in Brooklyn with a floating-rate mortgage, as there were no fixed-rate loans on offer. It closed at 15.5% and floated to 17.25% in the first six-months. At work, no credit analysis could be presented without a scenario including a 20% prime rate. Money market funds were yielding 15%. Companies switched from FIFO to LIFO inventory accounting for their tax books. The housing market was dead. The Wall Street Journal had a front-page column every week listing numerous recent bankruptcies.

Today the debate centers on the massive increase in government borrowing and the attendant monetization of that debt by the Federal Reserve. Now teetering atop a massive $7.4 trillion in assets it is not clear the Fed has a way down from that mountaintop. The Fed balance sheet is up 704%, since the 2008 mortgage meltdown. It is not so extreme to believe that the Fed has lost some control over monetary policy.

We feel sorry for Janet Yellen, former Fed Chair and Biden’s new Treasury Secretary. A very talented economist, she finds herself, perhaps for the first time, in a world where facts and analysis are not the most important in building a policy perspective. As President Biden has had occasion to instruct us from the campaign trail, “We choose truth over facts.” That truth is, of course, rendered by a political process, rather than economic analysis. It must be with a certain discomfort that Yellen receives the wisdom of Biden’s Modern Monetary Theorists, arguing that, “the U.S. can never run out of dollars”.

M2, (a measure of money the Fed uses) has increased 25.5% in the last year to $19.4 trillion (see the graph nearby from FRB data). Recalling Milton Friedman’s dictum that, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”, we note that output has not increased 25%. With all this money sloshing around, what is happening to prices?

Not much – yet.

Two countervailing features are balancing that whopping increase in money. One is a well-understood velocity of money principle posited by Irving Fisher in 1911. The second involves the macro impact of technology and has been largely ignored for the last 20 years for reasons that are difficult to comprehend.

The velocity of money derives from Fisher’s formula, MV=PT. The supply of money times its velocity (how often it changes hands) is equal to the price level times all transactions. The velocity of money is in long-term decline since 1997 and most recently literally rolled off a cliff (see nearby graph). The decline in velocity no doubt offset some good portion of the runaway growth in the money supply – producing prices that are more stable, all other things being equal.

Throughout history every advance in communication and transportation technology has resulted in lower prices. This is as true today as it was in the time of the telegraph and clipper ships. As a global and mostly ubiquitous jump in communications capability, the Internet has had dramatic macro economic effects all of which are deflationary.

Consider the importance of quick and simple global price discovery, where my local shop needs to compete with a supplier in Taiwan. The low cost of entry for new businesses and the easy access to new supply sources has dramatically increased competition. Assets that were previously unused now become liquid and more valuable, increasing supply, as homes turn into hotels and personal cars into taxis.

Fundamentally, inflationary behavior is a function of what people think about the future. In that regard we draw your attention to the green line in our little graph showing expectations for price increases rising but still at a modest level (1.8%).

Where are the inflationary pressures? We find the greatest increases in goods that would have the biggest impact on those in the lower income levels who are also the mostly likely to be out of work. Since March prices have risen most for utilities (2.8%), meat and poultry (4.8%), appliances (10.7%) and used cars (11.3%).

There was an additional warning from the consumer confidence survey, which dropped from 79 to 76.2 versus 101 a year ago. The main driver was not current conditions, which seem pretty awful, but rather expectations about the future, especially for households with income below $75,000. Faced with difficult job prospects and rising prices, it is no wonder that the prospects of a modest bonus from the government have not assuaged those worries.

A focus for the new government should be to move that confidence index higher. As FDR had it on the eve of the depression, “the only thing we have to fear is fear itself.”