Follow the Money

A special report on inflation, with a focus on the United States

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This report consists of two key parts. The first provides a detailed analysis and breakdown of inflation and its drivers, whilst the second specifically applies this theory and analysis to the current bout of high inflation being seen in the United States (US).

In contrast to the many policymakers and economists who argue that pandemic related supply chain constraints, or even that corporate profiteering may be chiefly responsible for inflation, this report argues that the key driver of the current high inflation being seen in the US, is the extreme increase in the money supply that occurred as a result of enormous federal government spending, and Federal Reserve (Fed) policies in response to the COVID-19 (COVID) pandemic. On an annual average basis, the Year-on-Year (YoY) percentage increase in the M2 money supply in 2020, was the second largest in the US’ post-Civil War history.

In contrast to the environment that was present during most of the post-COVID period (i.e. since March 2020), the current set of economic circumstances has vastly shifted. Instead of huge government stimulus, zero interest rates, and aggressive Fed bond buying, the 12-month rolling federal government deficit has shrunk to its pre-COVID level, and the Fed is reducing the size of its balance sheet and quickly raising interest rates. This has resulted in one of the sharpest decelerations in the YoY growth rate of the US’ M2 money supply in its history.

While lower YoY comparables will likely prevent a major deceleration in the Consumer Price Index (CPI) throughout the rest of 2022, and lagging CPI rent indexes may keep the CPI elevated for longer than otherwise, in the absence of another surge in energy prices, the ongoing deceleration in M2 growth points to a significant likelihood that the YoY rate of CPI growth peaked in June 2022, and that there will be a significant reduction in inflation over time. Should the M2 money supply continue to flatline for an extended period, an eventual move from high inflation, to deflation, cannot be ruled out.

With the stimulatory effect of a money supply growing at a much faster rate than prices reversing to create contractionary economic pressures as inflation is high and M2 flatlines, the Fed’s continued hawkish stance suggests that there is a significant risk that it repeats its previous mistakes in reverse—i.e. after firstly ignoring the impact of extreme money supply growth in creating the current high inflation, the Fed may not recognise the importance of flatlining M2 in drastically reducing inflation. The CPI’s lagging measurement of rental costs could also increase the risk of policy mistakes from the Fed. As opposed to inflation, the greater risk now firmly appears to be that the Fed excessively tightens monetary conditions, leading to a severe economic downturn.

Steven Anastasiou