The Federal Reserve just added $4 trillion to its balance sheet, with many market participants and the general population bracing for inflation, including higher asset prices. This fear is from Monetarists’ thought, who believe that inflation was a direct result of the money supply; however, Keynes argued that prices, resulting from economic pressures, are more reflected in inflation.
Let’s go back to the Great Recession and the unprecedented monetary policy at that time and the results. Despite the Fed increasing its balance sheet by $750 billion, inflation did not ensue over the following 10 years. One of the primary reasons for this was the velocity of money decreasing prior to money creation. The increase of money supply offset the decrease in velocity, stabilizing and reviving the value of assets. These assets were previously propped up by consumer leverage and low mortgage rates.
With low borrowing rates and an increase in the money supply, the economy recovered, but inflation did not set in as expected. This was mostly due to low wage growth and consumer deleveraging. Further, low corporate borrowing rates made goods in greater supply such as oil which collapsed from $100/barrel to $25/barrel in 2012. Companies that should have collapsed after 2009 took advantage of cheap money to keep their business afloat but dumped goods into the market at low prices to generate cash flow to make their debt service.
Some of the more famous zombie companies, such as Sears and Toys“R”Us, that were supported in this era eventually unwound as cash flow was no longer sufficient to cover the debts. Many companies with high debt and low cash flow still exist but likely will be unwound quickly during the Q2 of 2020 due to lack of commerce and the upcoming debt maturity wall.
In all, low wage growth failed to create more demand, while supply continued to increase. These forces pushed many prices to go lower or flat, despite the velocity of money slowly increasing alongside the new reality of money supply.
During this next adventure, $4 trillion is being created out of thin air in the US, along with many other countries. Although there are several situations in which inflation could occur this time, it is unlikely. The increase in the money supply will offset the unwinding of leverage by corporations.
There is an abundance of many goods, such as oil and gas, food, and other commodities. More importantly, there is a general lack of demand for non-essentials. With many countries on lockdown, certain goods and services have no demand, and though there will be some pent up demand for some, generally people will be used to living without certain luxuries. Furthermore, with the current high unemployment rates, and people switching to earning unemployment insurance it is likely that for a long period of time effective wage rates will be lower.
The long tail risk at the moment for high inflation is the supply chain for food. There is already a major disruption in the supply of wheat from Kazakhstan, as pointed out by Stacy Herbert. Kazakhstan, the 10th largest exporter of wheat and is responsible for 2.5% of all global wheat supply, has suspended exports of food staples. Though this seems insignificant, other countries may follow suit in hoarding and closing exports of wheat and other foods. The United Nations’ Food and Agriculture Organization has warned of “a looming food crisis unless measures are taken fast to protect the most vulnerable, keep global food supply chains alive and mitigate the pandemic’s impacts across the food system.” If this trend continues, protectionist policies could drive global food prices much higher. There is a 20–30% chance of this occurring, which we should be mindful of.
“Some countries could resort to trade restrictions or aggressive stockpiling in a bid to safeguard food security, which could quickly escalate and support grain and oilseed prices.” -Fitch Solutions
Note: This article was originally published April 5, 2020 on Exponential's Medium page