Price inflation normally comes from too much money chasing too few goods and driving prices higher. There has been no lack of articles over the past few years prognosticating about the inflationary risks to the Fed “printing money.” Three rounds of Federal Reserve quantitative easing have pushed $3.5 trillion into the system. Quantitative easing has allowed banks to build up reserves, so they have plenty of money to lend. Why hasn’t it driven inflation upward?
Economists use two primary metrics to measure the speed and magnitude at which money moves through the economy: the “money multiplier” and the “velocity of money.” The money multiplier measures how often a dollar gets loaned. Money velocity measures how quickly money moves in and out of consumers’ pockets. Both of these measures are at historically low levels. Moneyness just isn’t what it used to be.
Take the fantastic life of a single U.S. dollar during “normal” moneyness, back in 2005. The dollar is lent by the bank to a consumer to finance his mortgage. The home seller invests that dollar in Ford corporate bonds. Ford uses the borrowed dollar to pay an employee in charge of a new R&D initiative. The employee uses the earned dollar to buy her husband a workout at the local gym. The gym instructor deposits the dollar in his savings account, to be used by the local bank to finance yet another mortgage. That single dollar has contributed several dollars to the GDP and maybe helped raise prices a little as a result.
Compare that with the standard story of two dollars in today’s economy. The first dollar sits in bank reserves. The Ford employee earns and saves the second dollar. Fin.
In this case, twice as many dollars does not equate to an economy with “more money.”
For better or worse, the money multiplier and money velocity have collapsed since 2008. Money has lost its moneyness. Banks are more careful about to whom they lend, and households are wary of over-borrowing for fear of a return of the Great Recession.
So the fuel is there for inflation, but it has not yet been set into motion. The velocity of money, bank lending, and consumer debt are all key areas where we will look for signs of inflation in the coming months.
The turn of the year offers an opportunity to look back at how 2013 fits into the historical inflation picture. Retail prices as measured by the CPI increased incrementally during December, capping a year of modest inflation.
To put this in perspective, we thought it prudent to look back at yearly inflation since 1930. In roughly three of four calendar years, annual inflation has been between 0 and 6 percent (See Chart 2a). At 1.5 percent, 2013 falls squarely among the “typical” years.
Historically, 10-plus percent inflation has happened four times since 1930. The years were 1946, 1974, 1979, and 1980.
Perhaps of equal relevance to the current situation is a historical look at how inflation has changed from one year to the next. That is to say, what can history teach us about how rapidly inflation changes year over year? The data show that there are also four years (1933, 1941, 1946, and 1950) during which inflation “jumped” by as much as 8 percent (See Chart 2b).
Finally, we look at how often inflation spiked following years of modest 0 to 3 percent inflation. We find two spikes (1941 and 1946) of 8 percent or more out of 40 possible years (See Chart 2c).
Inflation hawks will often argue the potential for 10 and 15 percent inflation in the near future. These levels are certainly not unprecedented. This simple analysis of historical outcomes, however, suggests about a five percent probability of inflation hitting ten percent or above in the coming year. When we discuss the risk of rising inflation, a more likely outcome is two to six percent.
As a thought experiment, let’s review the circumstances that caused spikes following a year of modest inflation. In 1941, the first of the two spikes, the Federal Reserve Board reported “a record growth of bank credit, bank deposits and currency along with a 50 percent decline in the excess reserves of its member banks.” This was naturally the result of the onset of World War II. The report also notes that “over one-half of the nation’s productive forces are now devoted to war production,” indicative of too few goods available for purchase.
The year of the second spike, 1946, was widely predicted to be an economic bust as a result of the end of World War II. People were worried about the availability of new jobs. However, the surprising post-war boon led to a significant spike in inflation.
Although major worldwide events the likes of WWII are improbable, today’s level of excess bank reserves is unprecedented. From 1959 through August 2008, the maximum (inflation adjusted) level of bank reserves was about $155 billion. The average monthly level was about $46 billion. Compare that with the nearly $2.5 trillion in bank reserves today. When bank reserves dropped precipitously in 1941, bank reserves were about 1/25th as high as today’s levels (inflation adjusted). A big increase in moneyness would lead to the deployment of excess bank reserves and have enormous impacts on inflation.
Monthly Inflation Measures
Retail and Wholesale
The broad-based Consumer Price Index (CPI) was up 0.3 percent for December, bringing the annual increase to 1.5 percent. The CPI was led upward by energy prices, which jumped 2.1 percent in December following two consecutive decreases. The CPI Core, which excludes food and energy, was up 0.1 percent, bringing the yearly total to 1.7 percent. The CPI Core has been consistent, with year-over-year increases between 1.5 and 2.3 percent since mid-2011.
The pattern of services prices rising and durable goods prices falling continued in December. Durable goods prices were down 0.8 percent in 2013, while services prices increased 2.3 percent. This dichotomy has remained consistent since mid-2012. Import prices for the year also decreased, putting additional downward pressure on domestic prices.
AIER’s proprietary Everyday Price Index (EPI), which looks specifically at the products that consumers are purchasing on an everyday basis, was up 0.2 percent for December. The EPI lagged the CPI for the year, up a more modest 1.2 percent for 2013. Although the previous four years had seen EPI increases nearly double CPI increases, 2013 was an exception due to relatively tame increases in the price of gasoline. The EPI excludes one-time items such as car and house purchases, and weights more heavily on items such as food and gas.
The PPI, which measures wholesale prices as charged by producers during different stages of production, indicates gradual upward momentum for December. The prices for finished goods (e.g. the price of goods sold directly to retailers) increased 0.4 percent in December. The year-end inflation figure settled at 1.2 percent after a 1.4 percent increase in 2012.
Demand and Supply
Where we normally discuss the factors that establish supply and demand for goods and services, this month we add a discussion of the supply and demand for credit (lending and borrowing).
Goods and Services: Despite preliminary reports to the contrary, retail sales figures for December were strong, up 0.2 percent on a monthly basis (seasonally adjusted) and up 4 percent on a year-over-year basis. Likewise, consumer discretionary spending rose about 4 percent last year (data for December are unavailable as of this writing). Although spending increases were not as high as 2011 and 2012 (4.8 percent and 4.4 percent, respectively), they still indicate a relative strength in the economy and a strong demand for goods. Real average earnings fell in December and were mostly flat for year.
One potential impetus for inflation would be if spending continued its upward trend while earnings remained flat. This scenario would likely require increased borrowing.
The supply of goods, as measured by the industrial production index (IPI), continues to soar. The IPI hit an all-time high, with relative strengths in construction and consumer goods. Coupled with increased production, capacity utilization increased to 79.2 percent. There is some evidence of supply bottlenecks at a utilization of around 82 percent, but the current rate is in line with the average rate of 80.2 percent from 1972 through 2012. Nonfarm business sector labor productivity also increased at a 3.0 percent annual rate as of the last available report (Q3 2013).
All of these factors point to increasing supply and increased demand for goods and services. This pattern usually reduces the risk of inflation unless bank lending becomes more active.
Borrowing and Lending: Americans seem to have found a new sense of personal financial responsibility, which is showing itself as low demand for borrowing. Perhaps in response to the recession several years ago, people seem to be more cautious about amassing credit card and other debt. As evidenced by revolving consumer credit outstanding (i.e., credit card debt), aggregate credit card debt fell from mid-2008 through late 2011 and has increased only incrementally since then. This borrowing pattern helps explain the low velocity of money and is corroborated by data from the Senior Loan Officer Survey, in which only eight percent of respondents indicated stronger demand for credit card loans. Meanwhile, banks have been amassing reserves, limiting the amount of cash entering the market. These factors point to a story of reduced supply and demand for borrowing (See Chart 3).
Awaiting a Shift
All of the factors discussed n this report present a picture of inflation pressures in reasonable balance. But we can only hope that balance persists. An upward shift in moneyness will certainly be stimuli for increased inflation.