Why Isn’t Inflation Higher – part 2

In this second part of our article on why isn’t inflation higher we look at the relationship between the monetary base and the money in circulation.

Even though the monetary base has increased fourfold in the last ten years we still aren’t seeing the flow-through effect of this into the real economy. Banks aren’t lending normally today, partly due to their impaired balance sheets but also due to regulation and less risk taking.

As many small business owners and individuals have noticed it’s not easy to get a loan today as you will have to make it through cumbersome loan application processes. It’s mostly the banks and big institutions that have access to capital currently.

The graph below illustrates the difference between growth in M1 money supply (M0 and M1, also called narrow money, normally include coins and notes in circulation and other money equivalents that are easily convertible into cash) and the M2 money supply (M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds).

why_isnt_inflation_higher_2 copy

Source: www.data360.org

The M2 money supply serves as a good indicator of money in circulation, which easily can drive price increases in goods and services. Clearly, we aren’t seeing much of a spillover effect of the M1 money supply into the real economy. Since 2009 increase in bank loans have furthrmore almost been flat.

So while we are seeing increasing asset price inflation, primarily in real estate and in the stock market, as well as a general increase in the cost of goods and services, we aren’t seeing it on a scale that would be proportionate to the actual increase in the monetary base. If that were the case then inflation would be considerably higher. Even though we gradually are heading in that direction, since money is seeping through the economy, it can be of interest to look into this topic further.

What are the prospects for a shift in the flow-through effect of money and what would be the catalysts?

The prospects for even higher inflation almost seem inevitable, as we’ve discussed before. Rising inflation can happen slowly as the velocity of money increases or with an external event like a shock sell off in the bond markets.

When it comes to the Feds stimulus efforts there is no way for them to extract themselves from the market without serious repercussions. Tapering the stimulus, which is closely linked to the discussion of extraction, is furthermore something which the Fed would have a very difficult time to do, as it would create significant turbulence in the bond markets.

As other central banks are decreasing their purchases of U.S. government debt, as illustrated by the graph below, the Fed has actually stepped forward as the single biggest buyer.

why_isnt_inflation_higher_3 copy

Source: Reuters

Between the start of QE3 in the beginning of 2013 and July 2013 the Fed have purchased 90.5% of net issuance of gross federal debt according to ShadowStats.com.

This is not a sustainable situation. It’s furthermore not a situation which the Fed ultimately will control since they don’t control long term interest rates. Inflation will continue to increase but with a crack in the treasury markets we could see a significant shift in the M2 vs M1 money supply, resulting in a rapidly increasing level of inflation.


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