The inflation debate is overheating. For us, however, the risks are overhyped.
As markets potentially overreact to transitory CPI numbers this year, it could deliver a number of opportunities for fixed income investors to “buy the dips.”
Why Is Everyone Worried About Inflation?
The case for high inflation is straightforward. The authorities are vigorously “printing money.”
The Fed is committed to QE, and the Biden administration is committed to fiscal stimulus. The administration is fresh from passing the $1.9 trillion American Rescue Plan with its sights on a $2 trillion (over eight years) infrastructure bill.
Adding fuel to the fire, the end of the pandemic is potentially now in sight. Employment is returning, and consumers are increasingly able to spend their amassed savings.
Although this appears a compelling narrative, a deeper assessment indicates more of a transitory flicker of inflation than a bonfire to us—potentially at least until 2023.
Money Supply Growth Is Less Scary Than You Think
Market participants are often shown frightening statistics like the one below, charting the spike in the annual growth of “M2” money supply (Figure 1).
But when we adjust it to reflect only money circulating around the real economy, it looks far less alarming (Figure 2)
We call this the “M2 illusion.” The official statistic is, to a great extent, reflective of the Fed’s QE—which has resulted in elevated levels of bank reserves resulting from liquidity requirements from Dodd Frank regulations. Therefore, the proceeds from Fed purchases don’t make it into the real economy.
So, while President Biden’s fiscal agenda has undoubtedly injected cash into the hands of the consumer, which will have some inflationary effect, for now we do not anticipate a significant change.