by Jim Welsh
Macro Tides Monthly Report 01 February 2021
The January Marco Tides was entitled “Will the Consensus Be Right in 2021?” and one of the consensus trades highlighted was the almost universal view that the Dollar would continue to fall. This view was shaped by the Dollar’s -12.7% decline throughout 2020 after peaking on March 23 at 102.99 and closing at 89.94 on December 31. The fundamentals most often cited by Dollar bears is the federal budget deficit and trade deficit which increase the amount of Dollars flowing overseas and in the U.S. as measured by M2 money supply.
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The logic is straightforward – more Dollar supply will exceed demand and result in a lower Dollar. The huge budget deficits in the wake of the financial crisis lifted Federal Debt as a percent of GDP from 62% in 2007 to 100% in 2013.
The COVID19 Pandemic has caused the Debt to GDP ratio from 102% to 137% in less than a year compared to the six years it took after the financial crisis for a similar increase.
Dollar Perma Bears
The rapidity of the increase in the federal budget deficit in 2020 and persistent rise in the Debt to GDP ratio since 1981 when it was just 31% has spawned a cadre of vocal Dollar bears that always tout ‘The sky is falling’ perspective. One of the most vocal is Peter ‘Shrill’ Schiff of Euro Pacific Capital, who has been warning of the Dollar’s demise for a long time and who is always a big proponent of Gold.
September 25, 2009 – Peter Schiff: U.S. Stock Rally and Dollar Doomed, Gold Going To $5,000
The worst is not over, according to Euro Pacific Capital’s Schiff, who predicts the Dow will fall another 90% from current levels when measured against gold. A longtime dollar bear and gold bull, he foresees gold hitting $5000 per ounce “in the next couple of years,” and predicts the Dow and gold will trade on a one-to-one ratio vs. the current level of around 9.7-to-1. Schiff’s forecast is based on his view the U.S. dollar is going to collapse under the weight of our massive deficit and reckless policies of the Obama administration, which he compares to the massive spending programs of the 1960s, which paved the way for gold’s ascent in the 1970s.
(The actual low was 7449 in March 2009 six months before this interview. If the Dow had fallen another 90% from its September 25, 2009 close of 9,665 it would have subsequently fallen to 966. Gold traded up from $1000 in September 2009 to $1920 in September 2011 before falling to $1046 in December 2015)
Gold
May 2013 – Dollar Bears Aren’t Wrong … Just Early
“The dollar is going to collapse if [Fed Chairman] Ben Bernanke doesn’t reverse course,” Schiff said in an interview with Yahoo! Finance. “And if he does, the whole phony economy that has been built on the foundation of stimulus is going to collapse as well.”
(In May 2013 the Dollar was trading around 83.00 and subsequently rallied to 103.82 in January 2017, an increase of 25%. The Fed began to increase rates in December 2015 and the economy continued to hum along until the Pandemic hit in early 2020 after recording the longest business expansion in U.S. history.)
Dollar
July 2014 – Peter Schiff on the dollar crisis, Fed and future of gold prices
“Well hopefully the dollar won’t be worthless. I mean it will be worth a lot less than it is today, but worthless would mean zero. So if the dollar were worthless, you could have a hundred million of them and not be able to afford a subway ticket. If gold goes to $5,000, will the percentage increase in silver be greater? Well, my guess is that it would be. My guess is that when gold is at $5,000, I’m saying “when” because I believe that it’s inevitable, but when gold’s at $5,000, will silver be at $100? Because $100 silver is a fivefold increase. $5,000 gold, what is that, well maybe silver will be $150 or $200 when gold’s at $5,000.”
January 25, 2018 – Peter Schiff Sees Collapse In Both US Dollar and Government Debt
But unlike the criticism Mr. Schiff has delivered over the last few years, he now sees a collapse in the value of the US Dollar, the US equity markets as well as US bonds. He sees these events as being likely in the near future, with lots of factors in play that could spark the conflagration of a lifetime.
(On January 25, 2018 the Dollar was trading at 89.00 and would subsequently rally to 102.99 in March 2020. The 10-year Treasury yield was 2.62% on January 25, 2018 and on its way to 1.43% in August 2019 before the COVID-19 crisis brought it down to 0.40% in March 2020. The S&P 500 was 2839 on January 25, 2018 and would drop to 2351 in December 2018 before hitting an all time record of 3393 in February 2020.)
10-year Treasury Yield
July 30, 2020 The Dollar is not just going down, it’s going to crash
The following is from an interview with Liz Claman from Fox Business news:
“I think the dollar is going to keep drifting down until it collapses. And this is going to usher in a real economic crisis in America, unlike something we’ve ever seen. Because it’s going to force the Fed to choose between saving the dollar, and dumping all the bonds it’s been buying, letting interest rates rise sharply, forcing the US government to slash spending right now and abandon all these stimulus plans, or just let inflation ravage the entire economy and wipe out a generation of Americans.”
Liz Claman asked Peter what is the trade given what’s coming down the pike.
“Get out of dollars. Number one, yeah, own gold and silver. The gold and silver mining stocks are killing it, but they’re just getting started. I mean, these stocks, I think, can go up 10, 20 times in dollar terms.”
(Since July 30, 2020 and through January 28, 2021, the Dollar is down -2.5%, Gold is off -5.7%, Silver is up +8.2%, but Gold stocks as measured by GDX have been slammed by -19.5%.)
January 28, 2021 – Silver Surges as GameStop Day Traders Move Into Other Assets
Some notable precious-metals bulls were taking notice of the big swings. Peter Schiff, CEO of Euro Pacific Capital, said on Twitter that the move into silver shows that the Reddit day traders are getting smarter because silver miners have good value:
“Silver stocks are actually cheap, and represent good investment value.”
(Reddit traders will be heartened by Mr. Schiff’s assessment of their improving investment prowess.)
The quality of the investment advice Mr. Schiff has provided for more than a decade speaks for itself. It is remarkable that Mr. Schiff is still sought out as a speaker and ‘expert’ at investment conferences and in the media. Clearly there is a demand from those who find dire warnings of impending doom attractive. Mr. Schiff uses scary outrageous headlines to garner attention (and others like him) and I would suggest taking any extreme warning published by anyone with a grain of salt, since the primary goal is to grab your attention rather than providing insightful analysis.
Mr. Schiff’s forecasts are based on an overly simplistic investment thesis that has a ring of fundamental logic, which makes it easy for the unsophisticated to latch onto. Large budget deficits and trade deficits are unhealthy, but that won’t necessarily keep global investors from buying the Dollar or Treasury bonds in an uncertain world. The Federal Reserve dramatically expanding its balance sheet may end badly, but in the short run it has forestalled a deeper and longer lasting economic contractions after the financial crisis and COVID-19 Pandemic that would have inflicted far greater economic suffering on those who can least afford it.
Gold is often pitched as the best investment to own during a crisis which is why investors are often urged to maintain at least a 5% allocation to Gold as insurance. In May 2008, and just a few months before the financial crisis, Gold traded up to $1014. When the crisis erupted in October 2008, Gold traded down to $681 more than 30% below its May 2008 level. (See chart on Page 3.) As the COVID-29 Pandemic unfolded, Gold rose to $1686 in February 2020 before falling to $1452 in March a decline of -13.8%. In fairness it can be argued that Gold eventually rallied to higher prices after each crisis had passed, but it is ironic that during each crisis it declined.
Gold is an asset and during a liquidity crisis that causes stocks, bonds, or other assets to lose value quickly, investors are often forced to sell assets including Gold to meet margin calls, and during the last two crisis’ that’s what occurred.
Is a Dollar Crash Coming Soon?
The biggest risk in coming years is the status of the Dollar as the world’s Reserve Currency. Although the Dollar’s share of global reserves has slipped from 70% in 2000 to 60% now, it remains the dominant currency by far for a number of good reasons.
No other nation has a debt market that can match the depth and liquidity of the U.S. Treasury market and corporate bond market. In the foreign exchange market the Dollar is part of about 85% of all currency transactions, and more than 60 countries peg their currencies to the Dollar. All major commodities including oil, industrial metals, agricultural products, and Gold are priced in the Dollar.
Although the Dollar’s role has diminished modestly in recent decades, the Dollar is clearly the dominant currency and that’s not likely to change much in the next 10 to 20 years.
If the Dollar is going to collapse from the dual weight of the budget and trade deficits, it will first break below important long term price support. A breakdown of meaningful support will provide us an early warning of much more trouble to come, which is why incorporating technical chart analysis must play a role in analyzing the Dollar’s future.
Observing the gradual change in the Dollar’s fundamentals is of value, but is unlikely to provide little guidance as to when the tipping point has been reached. This is where the combination of fundamental analysis and technical analysis can prove most helpful. Technical analysis can provide insight when the risk from fundamental factors like the budget and trade deficits are increasing to a dangerous level and often well before a ‘Dollar Crisis Shakes Global Financial Markets’ is the headline.
The range of 87.50 and 88.50 on the Dollar index has been a critical pivot point since 2008. The Dollar rallied from a low of 70.00 in March 2008 to a high of 88.50 in November of 2008, which was tested again in March of 2009. The Dollar subsequently fell to 75.00 in December 2009, only to rally up to 88.70 in June 2010. By May 2011 the Dollar had fallen all the way back to 72.70. The Dollar index broke decisively above 88.50 in December 2014 and by March 2015 traded up to 100.39. After peaking in January 2017 at 103.82 the Dollar fell for 13 months before bottoming at 88.25 in February 2018.
Dollar
This chart analysis indicates that any decline below 88.00 in coming months will open the door for a decline to at least 75.00 and potentially 70.00 – 72.00 in the Dollar index. The key takeaway is that the Dollar will fall below 88.00 well before a ‘Dollar Crisis’ makes headlines. This makes the integration of technical analysis with the Dollar’s fundamentals indispensible.
Sentiment and positioning can provide valuable insight as to whether an important support level is more likely to hold or not. Foreign currency traders have become increasingly negative toward the Dollar as it has declines since peaking in March 2020, and have taken positions to benefit from a continued decline.
Some of the price weakness in the Dollar has come from foreign currency traders from either shorting the Dollar or from buying other currencies with the expectation they will rise relative to the Dollar. The short position against the Dollar is approaching levels last seen in late 2017 and the first quarter of 2018 when the Dollar bottomed at 88.25.
The extreme in negative sentiment and positioning increases the likelihood that the Dollar will not break below this important support and will instead rally. Given this analysis it is irresponsible to proclaim that the Dollar is about to collapse, until the Dollar falls below 88.00 at a minimum.
Euro Strength
Foreign currency traders have taken a large long position in the Euro which has helped it rally +15.6% versus the Dollar since March 23. As discussed in the January Macro Tides. I thought such a big increase in the Euro’s value would get the attention of EU policy makers:
“The Euro has rallied +15.6% since bottoming on March 23 through December 30. A stronger currency makes European exports more expensive and increases deflationary pressures. This is neither good for economic growth or making progress towards the ECB’s goal of getting inflation up to 2.0%. There is a good chance that in the first half of 2021 ECB president Christine Lagarde will express concern about the Euro’s strength, which would give currency traders a strong signal to sell the Euro and potentially short the Euro.”
In early January the Euro rose to a six year high against the Dollar which did get the attention of EU policy makers. On January 27 Klaas Knot, who is the head of the Dutch central bank and a member of the ECB governing council, was interviewed by Bloomberg and was asked about the ECB’s inflation target and the strength of the Euro:
“That is something we of course monitor very, very carefully. It’s one of the factors, not the exclusive factor, but one of the factors we take into account when arriving at our assessment of where inflation is going to go.”
Klass went on to say that the ECB has the necessary tools, including interest-rate cuts, to prevent any further strengthening of the euro undermining inflation. What Klass did not mention was jawboning by members of the ECB to communicate to foreign currency traders that it’s OK to sell the Euro.
Klaas’s comment is almost verbatim those expressed by Mario Draghi in March 2014 which I discussed in the April 2014 Macro Tides:
“At the ECB’s monthly news conference on March 6, Mario Draghi said that the strength in the Euro since July 2012 had shaved .4% off annual inflation.
“The strengthening of the Euro exchange rate over the past one-and-a-half years has certainly had a significant impact on our low rate of inflation and, given current levels of inflation, is therefore becoming increasingly relevant in our assessment of price stability.”
Foreign currency traders got the message after Draghi repeated his assessment after the May 8, 2014 ECB meeting:
“The ECB’s governing council is comfortable to easing policy at their meeting in early June. The strengthening of the exchange rate in the context of low inflation is a cause for serious concern.”
After peaking at 1.399 on May 8 the Euro plunged to 1.046 in March 2015.
Just as in 2014 it may take more than one comment to get foreign currency traders attention. The high in early January was 1.2390 and any move above this level is likely to illicit more comments by a members of the ECB governing council expressing displeasure about the Euro’s strength. A decline below the horizontal trend line at 1.2050 should lead to additional weakness (Chart below).
The Euro comprises 57.6% of the Dollar index so any weakness in the Euro will give the Dollar a lift in the short term. If the ECB pursues a weaker Euro through additional rates cuts or jawboning, the Dollar will rally despite record setting federal budget deficits and a large U.S. trade deficit. The trend in the Dollar is determined by more than just the economic fundamentals of the U.S., which demands a broader understanding of global economics than hyperbole statements about a looming Dollar Crash.
Euro
The Global Vaccine Race
Containment of the virus is dependent on the pace of vaccinations and so far the results are less than optimal. As of January 29, 7.1% of the U.S. population has been vaccinated which has garnered a great deal of negative press. However, the U.S. is ranked fourth globally based on vaccinations per 1000 people through January 28.
Clearly, many members of the main stream media don’t have a global perspective of how the majority of countries are performing. Compared to the European Union, the U.S. looks great since only 2.2% of people of the 450 million people in the EU have received the vaccine, according to data from Oxford University.
The EU set a goal to have 70% of its population vaccinated by June but that now looks unlikely. AstraZeneca announced that it may only be able to deliver as few as 30 million of the 80 million doses it pledged in the first quarter of 2021 due to 11 manufacturing problems at a contractor’s plant in Belgium.
In addition, advisors to the German government warned on Thursday that AstraZeneca PLC’s vaccine shouldn’t be given to people over the age of 64 because of a lack of data about its efficacy in this group. Germany is currently vaccinating people over 80, and has only vaccinated two million people since Dec. 28, less than half the 5.7 million people over 80 in the country and about 2.4% of its population. German Health Minister Jens Spahn wrote in a tweet on January 28:
“Given the shortage of vaccines, we have at least 10 hard weeks ahead of us.”
The EU will struggle to reach its goal by the fall of 2020 and it may not happen until well into 2022.
Heads = Inflation
There is a chance of a demand driven wave of price inflation in advanced economies due to the increase in central bank balance sheets, unprecedented fiscal stimulus, and increased consumers saving. This outcome will be determined by the containment of the virus and all of its variants that leads to a synchronized spurt in global growth that is sustained.
According to Dr. Fauci the U.S. may not have vaccinated enough people to achieve herd immunity until mid to late fall, and the EU may take even longer. Emerging market economies will have a tougher time vaccinating their populations so COVID-19 and all of its variants will still have fertile environments to spread and mutate well into 2022 and beyond. The notion of synchronized global growth in the second half of 2021 seems unlikely given the vaccine challenges still ahead.
In the short term, headline inflation is likely to jump above 3.0% based on higher input costs and how the annual CPI is calculated. The headline CPI, which includes food and energy, plunged in April and May last year before rebounding in the summer.
The annual CPI is calculated by comparing the current month’s price level to 12 months ago. The increase for January and February in 2021 may be fairly muted since the CPI was up +2.5% Y-O-Y in January 2020 and 2.3% in February. However, when compared to April and May 2020 the headline CPI for April 2021 and May 2021 is going to rise sharply.
The headline CPI includes food and energy and both have been on a tear. Soybean, corn, and wheat prices have soared in recent months with soybeans 12 and corn up 68% since last August and wheat ahead by 39%. The increase in grain prices will continue to feed into many consumer foods, which will push up the cost of food at home and in restaurants by more than the 3.9% in the past year.
Crude oil and gasoline prices plunged as the Pandemic hit with WTI oil prices falling from $48.50 a barrel in January 2020 to $28.00 in April and nationwide gas prices dropped from $2.60 2020 to $1.74 in April. WTI oil prices have rebounded to $52.00 a barrel and gas prices are back up to $2.43.
Energy prices have been pulling headline inflation down but will begin to add to inflation meaningfully after April. Core CPI inflation will not increase that much, holding below 2.0%, as inflation from services remains soft and falling rents continue to hold down the owner’s equivalent rent component that makes up 42% of the core CPI, as discussed in the December 2020 Macro Tides.
The Federal Reserve has said it will look past any short term spurt in inflation and would tolerate core PCE inflation holding above 2.0% for a period of time. The Federal Reserve has communicated that it will be in no hurry to increase the federal funds rate. At the December 16 2020 meeting only one FOMC member supported an increase in early 2022, while 3 members expect the funds rate to be 0.375% at the end of 2022 (FOMC has 17 members).
If core PCE inflation holds below 2.0% as expected, members of the FOMC will remind investors that this is their key inflation metric and not the headline CPI, which is why patience is warranted.
The question is how will financial markets react, irrespective of FOMC member statements, if the headline CPI climbs comfortably above 3.0% for a few months? Few will suggest the Fed will increase the federal funds rate in 2021 but strategists will begin to discuss the potential that the Fed could move sooner than the end of 2022 to raise the funds rate.
In May 2013 the Treasury bond market threw a Taper Tantrum at the mere mention by Fed Chair Bernanke that the FOMC was considering tapering its monthly bond purchases. The 10-year Treasury yield rose from 1.61% in May 2013 to 2.72% in early July less than 10 weeks after Bernanke’s comment.
If headline CPI inflation pops as seems likely, it might impact a number of markets, especially if strategists begin to express the view that the Fed might remain patient in 2021 but not so much in 2022. Potentially, Treasury yields would rise, the Dollar would rally, but Gold would also rally as those who are always bullish point to the huge increase in money supply that is finally showing up in higher inflation. Don’t be surprised if there are articles hyping the coming wave of hyper inflation, which is what happened in 2011 right before Gold topped at $1920.
Dollar
The Dollar appears to have completed a 5 wave decline from the March 2020 high on January 6. The Dollar’s RSI recorded a positive divergence which is an indication that downside selling pressure is abating. The price reversal off the January 6 low has also generated a positive upside momentum signal.
“The 5 day moving average (red) has climbed above the 13 day moving average for the first time since early November. The Dollar should trade up to 92.00 where it will encounter resistance and how it manages to break above or fail at this resistance will indicate whether the Dollar will post a lower low in coming weeks. It is possible that the current rally is wave 1 of a larger advance, with any pullback bottoming above the January 6 low and represent wave 2. The initial phase of a rally will likely come from short covering which could be ignited by negative news out of Europe that weakens the Euro rather than good news that strengthens the Dollar.”
As noted, comments from an ECB Governing Board member on January 27 weakened the Euro and gave the Dollar a lift. The Dollar may push up to 92.00 – 92.50 in the next few weeks and then pullback. If the inflation news sparks talk of a less dovish Fed, the Dollar would subsequently rally up to 95.00 in the summer.
A Dollar breakout above 95.00 would signal more strength and likely be bearish for precious metals in the third quarter.
Gold
As noted in recent Weekly Technical Reviews:
“Gold is expected to fall below $1766 and could fall to the down trending line that connects the low in August, September 24, and November 30 which is near $1720. Although unlikely, Gold could fall to $1660 during a spike low. Gold dropped $304 from the high of $2070 to the low of $1766 (Wave a?), before rebounding to $1960 (wave b?). An equal decline would bring Gold down to $1656 (wave c?) If and when Gold does fall below $1766, the manner in which it does so will provide some clues as to whether the 14 trend line at $1720ish will be support.”
Once this correction is over, Gold is expected to rally above $2070, and a CPI printing above 3.0% could provide the necessary juice.
Silver
Silver has been expected to test and likely drop below the September 24 low of $21.78 before the next trading low is in place. However, the Reddit crowd has targeted a number of silver stocks within the Silver ETF (SLV), so SLV may not fall below its September 24 low of $20.45. Silver has been holding up better than Gold, so once the next trading low is complete, Silver is expected to outperform Gold during the next rally.
Silver could rally well above its prior high of $29.75, and if the Reddit crowd remains infatuated with Silver stocks, SLV could shine even more, with SLV blowing well above its prior high of $27.39.
10-year Treasury Yield
As discussed in recent Weekly Technical Reviews:
“The 10-year Treasury yield is expected drop to 0.95% before climbing to 1.266%. If the headline CPI news sends a shiver through the bond market, the 10-year yield will test and likely breakout above 1.266%. At some point in 2021, more likely in the second half of the year, the 10-year Treasury yield could spike up to 1.75% to 1.95%. This outlook will depend on whether the current vaccines prove effective against the new COVID-19 variants that are beginning to spread in the U.S.”
30-year Treasury yield
The first target for the 30-year Treasury yield is 1.94%, but the 30-year is expected to retest the breakout at 1.75% first. Long term the 30-year has the potential to rise to 2.15% to 2.35%.
Tails = Deflation
Although inflation has the potential to jump in coming months, longer term there are a number of forces that are likely to keep inflation in check. The amount of labor market slack is likely to remain high enough to keep wage increases small. Even if the federal minimum wage is increased over a number of years to $15.00 an hour from $7.25 since 2009, the impact will be small on overall wages.
In 2018 just 434,000 workers earned the federal minimum wage of $7.25, with another 1.3 million workers being paid less than the minimum wage. It is likely that many of these workers receive tips, which boosted their hourly wage well above the minimum. These 1.7 million workers represented 2.1% of all hourly paid workers in 2018. If the minimum wage is increased to $15.00 an hour those who are earning just above the minimum wage will also get paid more, so the ripple effect will modestly lift overall labor costs.
There are several flaws in the proposal to implement a $15.00 an hour federal minimum wage. The primary goal of any minimum wage should be to eliminate the number of workers who constitute the working poor. Anyone who works 40 hours a week but still struggles to pay rent, buy enough food to feed their family, clothe their children, and save a few dollars, should be paid more. The problem in deciding how much they should be paid varies tremendously depending on where they live. A $15.00 an hour minimum wage may not be enough in high cost cities like New York, Chicago, and Los Angeles. An increase to $15.00 will certainly help but many workers in high cost cities would still be considered working poor.
Conversely, a $15.00 minimum wage will put a lot of small businesses in low cost cities and rural areas out of business, which will cost many workers in those areas their job. A minimum wage that is tied to the cost of living in every city is a more intelligent solution than a minimum wage based on a placard slogan.
The minimum wage should also be tiered, so for first time workers with no experience receive a lower minimum wage. If an employer has a choice between a nice 16 year old and someone who has experience, the 16 year old won’t get hired if both workers are paid the same minimum wage. Everyone learns a lot from their first job – showing up on time, learning to follow instructions, learning social skills of interacting with the public, and the pride and satisfaction of receiving a paycheck. These are lifelong skills that are important, but may not happen until the 16 year old is older which will impact the rest of their working life.
If a $15.00 minimum wage is implemented, employers will determine whether it will be cheaper for them to use automation or technology that allows the customer to place their order. This is already happening and a $15.00 minimum wage will accelerate the adoption rate by employers.
Artificial Intelligence will become more widespread and weigh on job growth and wage increases in coming years. Since wages are the largest component of costs, all of these factors will keep wage growth in check and not allow core inflation to move appreciably above 2.0%.
The significant increase in government and private debt since 1980 has and will continue to weigh on economic growth. Since 1980 U.S. Private and Public Debt as a percent of GDP has soared from 160% to over 400%.
Even as the government, consumers, and corporations borrowed more money, lifting demand and GDP in the short run, each additional dollar of debt has been generating less and less GDP since 1982. The U.S. economy has literally been getting less growth for every additional dollar of new debt.
The increase in the M2 money supply has garnered a lot of attention especially by those who believe Gold is going to $5,000 since it’s presumed inflation will soon follow if not hyper inflation. Since the Federal Reserve pushed its policy rate below 0% in 2001, M2 money supply has experience three separate surges in growth prior to the current jump. (2001, 2009, 2011) Annual CPI inflation failed to increase after each of the prior surges in M2 and in fact trended lower. Although headline CPI inflation will jump in coming months, the longer term downtrend in the CPI is likely to reassert itself and keep inflation from spiraling upward.
As I discussed in the August Macro Tides entitled “Money Supply Growth and the Fed’s 2% Inflation Target“, much of the increase in M2 money supply will never find its way into the economy. If that analysis is correct the notion of demand push inflation simply won’t materialize in the next few years.
Despite debt goosing economic growth since 1980, average GDP growth has slowed from 4.3% in the 1980’s, to 3.6% in the 1990’s, to just 2.3% during the longest business expansion in U.S. history (126 months) that ended in early 2020.
The velocity of money is a concept that is integral to monetary policy. Here’s a simple formula:
GDP / M2 = Velocity
Conceptually when consumers and business feel confident they spend more so GDP growth improves, even if M2 growth is flat. Demand increases since the velocity of money – how fast it turns over – increases, without an increase in M2. During recessions consumers and businesses hold onto their money so velocity slows depressing GDP, even if M2 growth is modestly positive. When M2 money supply increases and the velocity of money increases, inflationary pressures are likely to increase, and fall if M2 and velocity decline. If M2 grows by 10% and velocity slows by 10%, inflation is not likely to change much. As M2 money supply growth increased in the last 20 years while average GDP growth slowed, the velocity of money has plunged.
Since 1900 and based on available data, there has been a good correlation between the 10-year moving average of the population growth of those 20- 54 and the velocity of MZM. (A broader measure of money supply than M2)
The Baby Boom began in 1946 causing the 10- year average of population growth to bottom in 1962. MZM velocity growth really kicked into gear in the mid 1960’s and rose sharply until peaking in 1981, just as the growth rate of the working age population topped. The peak in inflation coincided with the peak in working age population. Since the early 1980s, velocity and population growth have trended lower, irrespective of a number of short term bumps in velocity.
The sharp decline in births since 2007 suggests there will be another drop in the 10-year population growth rate after 2027. This decline could extend to 2040 or later since population grew by the smallest amount since 1921 in 2019. The economic dislocation from COVID-19 is likely to keep the birth rate low at least through 2021 and possible longer.
It is difficult to forecast a lasting and meaningful increase in inflation based on these monetary and population trends. These trends could be modestly altered should oil prices explode well above $150 a barrel or food shortages develop resulting in a big spike in crop prices. The last time this combination appeared was in the 1970’s (oil rose from $3 a barrel in 1973 to $37.00 in 1979), along with COLA clauses in union employment agreements that did contribute to a multi-year surge in inflation. However, based on what we know today and existing trends, deflation remains the greater threat.
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