One way to think about the economy is through the equation MV = PQ. Money times Velocity equals Price times Quantity. Also called the Equation of Exchange, MV = PQ is the basis for the Monetarist School espoused by Milton Friedman. MV = PQ implies that the money supply affects prices, other factors being equal. An increase in the money supply must lead to an increase in prices. After all, the Velocity of money is relatively constant, right? This is a concept at the 50,000 foot-level of macroeconomics. Big picture.
Money Supply
M2 Money Supply has been increasing rapidly in the US since the Financial Crisis of 10 years ago. The US Treasury prints the money but the Federal Reserve Bank controls the amount of money in circulation. Increasing the money supply is stimulative and it was thought that increasing the money supply would stimulate the economy and help bring it out of the Recession of 10 years ago. According to the St. Louis Federal Reserve website, the M2 money supply has increased from about $7.5 Trillion in November 2007 (the beginning of the Recession) to about $13.8 Trillion currently, a near doubling in about 10 years, and about 7% average per year. Here is a link to the website with that information:
https://fred.stlouisfed.org/series/M2
This money printing program has continued even in the past year, despite the better economic growth and unemployment indicators. M2 is up 4.7% just in the past year.
Inflation
One would think that higher inflation would result from the increase in the money supply, but it has not. Inflation has averaged about 1.6% over the past 10 years, according to the Bureau of Labor and Statistics. Here is the link to a chart of monthly inflation:
http://www.usinflationcalculator.com/inflation/current-inflation-rates/
Why has the huge increase in the money supply not caused inflation? There are many explanations out there for the causes of dormant inflation, including the following:
- Global labor surplus: There is no shortage of cheap labor in other countries, and as companies offshore their manufacturing, the cost of goods remains inexpensive.
- Slow Wage Growth: US wages have remained stagnant, and real wage growth (adjusted for inflation) has been near zero for the past 10 years. That 2% raise that you receive every year? It only keeps up with inflation rates
- Too much debt: At the household level and at the government level, we have been overburdened with debt. When your first priority is to pay your lender every month, you don’t have as much money to buy new stuff. This dampens inflation.
Velocity
Another explanation for low inflation is lower Velocity. Velocity is the number of times that a dollar is spent. When you earn money, you either spend it or save it. When you spend it, the company whose product you bought your product puts your spent dollar to use, either by paying its employees or buying new raw materials. Hence velocity. When you save it, you either put it into the bank so that the bank can, in turn, lend it out, or you invest it in a company’s equity, which, in turn, will also put it to good use. Hence velocity through savings or investment.
Where the equation has changed in the past 10 years is that companies have not been spending their cash as quickly. They have not hiked salaries commensurate with their profits, and they have not reinvested or redeployed their capital as much. Take Apple, for instance. Its iPhone has been a high profit-margin cash cow. Its employees are already highly and fairly compensated. They have not found another product that can replicate the profit margins that the iPhone can, either internally or externally. So, their corporate cash grows and grows – as of Q2 2017 they had over $260 Billion of cash. Presumably, it is mostly invested in US Treasury securities or derivatives thereof. The same phenomenon has occurred with banks. Instead of lending out money so that companies and businesses may grow, they have been increasingly just investing their excess cash back into riskless US Treasuries. Loan-to-deposit ratios nationwide trended downward through the recovery after the 2008 Recession, although that trend has turned around somewhat recently. Here is an article by Trefis Research that speaks to trends in loan-to-deposit ratios:
Why have companies and banks been hoarding cash instead of redeploying it back into the economy? Several reasons:
- Aversion to risk: Banks would rather take no risk and lend to the US Government than take a business risk by lending to companies. Banks got burned in the mortgage crisis so that dampened mortgage lending for a while, but mortgage lending is strong again. The penalties for making the wrong bet on risk are stout, so banks have not been taking a risk.
- Lack of accretive investments: As the stock market has risen, potential acquisition targets have been bid upward, so there are fewer businesses out there to buy that would add to corporate earnings.
- If you put your hand on the stove, you learn it hurts, so you don’t do it again: Businesses have been burned in the past by not having sufficient cash on hand, so they want to have enough for future rainy days. This is unlike any federal, state or local government out there, which have no rainy day funds. Maybe I am mixing too many metaphors.
- Regulations and Accounting Changes: This also falls into the contingency bucket. Businesses want to make sure they have enough cash to ride out any problems.
IMO
Again, this post is about big picture macroeconomic issues. I believe that there is a lot of “pent-up velocity” out there, for lack of a better term. Companies have been hoarding their cash for the past 10 years There are signs that this practice has been reversing. If it does, I believe there is a lot of potential growth out there that hasn’t been accounted for yet. 2% inflation is nothing to be worried about, yet. The Fed, as well as investors, have their collective eyes on inflation. As long as inflation remains in the 2% range, I think this economy and this stock market still has room to run.