There is a disconnect in modern base line economic thinking, which is that it is interest rates that control inflation. So when interest rates fell all those years ago from the 4% to 5% norm of the past, it was immediately thought inflation would erupt. It didn’t. Then we have inflation; it was immediately thought that high interest rates would cure inflation, and strangely, while you might think those punishing interest rate levels are the main driver of the fall in inflation, they aren’t.
So let me explain. It is the quantity of money that creates inflation, not the rate you can borrow or lend it at. Imagine a world of zero interest rates or even negative ones that rewarded borrowers where there was only very little money to be borrowed. It’s a world of a shortage of money, something that been a thing in past times. There is going to be no inflation because there is little money and lots of stuff to buy it with. In fact, you will have deflation even though interest rates on the little money available to be had is at a low rate. It doesn’t matter where interest rates are set, not enough money means falling prices. So let’s look at the opposite. People borrow all day long on interest rates of 25%-plus—it’s called credit card debt. When there is hugely more new money around than the supply of new things, up go prices. A load of people might not even need to think about borrowing because they are on the receiving end of the flow of new money gushing their way.
Money supply and interest rates don’t need to be joined at the hip and whether it is or isn’t, it is the money supply that sets the path of inflation not the interest rate.
Of course, if you jack up interest rates a whole crowd of people have their disposable income shrunk, but if at the same time the government was deficit spending like a sailor creating new money to do so, then you will get inflation however high the interest rates go. That’s why a Turkey or Argentina have incredibly high interest rates and continue to have incredibly high inflation, because at the core, it’s the printing press that causes inflation and cranking up interest rates won’t help you for long to get inflation under control, only changing money supply will do that.
While so many hang on what the Federal Reserve is going to do with interest rates, they are missing the big picture. What is the Fed going to do with money supply is the real question and as we know it has been tightening for a long time now by reducing their balance sheet and selling bonds back to the economy and thus mopping up cash. Mopping up cash will pull down inflation and it has.
Here is the chart of what it’s been doing and this is the master chart of all markets and much of the global economy:
If you want to know where all the inflation came from, there it is. So after the disaster passes the Federal Reserve is putting the inflationary cat back in the bag. It’s a straight-line process and it has clearly telegraphed it. That spike is where the small banks start to go bust for lack of money, and what do you know, out goes a wave of cash to keep the train on the tracks.
So now the Federal Reserve has said it is cutting the tightening, which is basically the opposite of printing money, it’s burning it. It’s been burning it and of course at some point folks are going to start going bust for lack of cash, just like Silicon Valley Bank did.
So when is that point?
There is no voodoo required, the system actually publishes a chart of the key value of too much money in the system. It’s the “reverse repo” facility balance, which is how much money the banks can’t find a use for and stick with the Fed for safe keeping and some interest.
And here it is:
You can see that the current inflation maps this chart of “excess” money in the system and you can see that compared to the low inflationary past, it’s a whole hill of inflation, thanks to economic Covid interventions.
It gets more interesting still when we focus in on the here and now, “what next’” part of the chart.
Tightening is over according to this chart and it syncs with the Fed saying it is slowing QT of their balance sheet by half.
Now you might say this has happened because the “wheels were about to come off” the U.S. economy. You might say as the Fed approaches a money supply equilibrium it doesn’t want to risk driving into a ditch by overshooting QT. You might imagine it doesn’t want any financial accidents leading up to the November election. You might wonder whether that extra money in the cookie jar is for a government hellbent on trillion dollar plus fiscal deficits. For whatever reason, it’s clear the Fed wants a few hundred billion in surplus money kicking around in the economy and it has pivoted away from a draconian QT to what looks like something approaching a neutral stance.
This might seem a bit of a yawn, but it means for investors conditions are yet more benign in the markets because it’s not only price inflation that excess money creates, it creates asset price inflation and in the end that is what we care about.
So for now and at least to November the going should be good and in a bull market, even a mild one, everybody can be mistaken as an investment genius.
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