Chart of the Week April 1, 2021

Will Skyrocketing Boost ? BEN MOHR, CFA, DIRECTOR OF FIXED INCOME, MANAGING PARTNER AND MOLLIE ZUGGER, RESEARCH ASSOCIATE

Economic recovery dynamics suggest less drastic trajectory and more muted, transitory inflation 30 12 2.4 0.016 2.2 0.014 25 10 2.0 0.012 20 8 1.8 0.010 15 6 1.6 0.008 1.4 0.006 10 4 1.2 0.004 5 2 1.0 0.002 0 0 0.8 0.000 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020 1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004 2008 2012 2016 2020 (L) Velocity (L) Inflation (R) Normalized Money Supply (R) Source: Bloomberg. Calculations: Money Supply (M2 y/y%); Inflation (Core PCE y/y%); Velocity (GDP $B/M2 $B); Normalized Money Supply (M2 y/y% / GDP $B).

As the continues, are rightly concerned with inflation, especially given the recent surge in M2 money supply,1 as shown in the purple line in the left chart. M2 has soared amid unprecedented levels of monetary and fiscal stimulus infusing markets and with . While an awash with cash may lead to concerns about runaway inflation, certain key economic recovery dynamics point to a less drastic trajectory and potentially more muted, transitory inflation. Juxtaposing M2 with core PCE inflation,2 shown as the green line in the left chart, we see that the two have not always been perfectly correlated. While an increase in the M2 rate has typically led to an increase in the core PCE rate, there are imperfections in the relationship. Inflation so far in the economic rebound has stayed low as the surge in M2 has been offset by a drastic decline in the ,3 shown as the orange line in the right chart. The velocity of money dropped off last year as money supply surged while consumer spending was down during the pandemic, though velocity has generally been in decline since 2000 amid the longer-term trends of aging demographics, greater , and weaker physical prospects relative to financial investment prospects. The increased money supply has so far not led to increased transactions, GDP per dollar spent, or inflation. The gray line in the right chart depicts M2’s annual rate of change normalized by annual GDP, showing that M2 increases from the 1990s, 2000s, and 2010s have been relatively stable as a proportion of overall GDP. In this context, while the surge over the last year is still evident, it is much less extreme.

INDEPENDENT INVESTMENT CONSULTING From here, as the economy continues to reopen, consumer spending on and services is expected to raise demand for input materials. This, along with COVID-related supply , may boost inflation temporarily. However, we expect supply chains will normalize and supply overall will adjust, reducing inflationary pressures. More importantly, in order for a pickup in inflation to be sustained over the longer term, economic participants would have to boost real purchases over purchases, counter to trends over the last 20 years. As the Fed eventually tapers its purchases and increases rates, the markets will be expected to absorb at least some of the greater money supply. M2 is ultimately expected to shrink relative to GDP as the economy rebounds, with velocity expected to correct upwards. In summary, we generally expect a more muted and transitory rise in inflation, holding all else equal. Core PCE may rise from the 1.5% at the end of 2020 to a range of 2.0–2.5% for 2021, encompassing the Fed’s projected 2.2%, but could then revert back down close to the Fed’s -term target of 2.0%, especially with the Fed’s eventual bond purchase tapering and rate hikes.4 Once the initial recovery is over and the economy trends back to normal, we could see factors like aging demographics and the trend towards services and tech over old economy sectors bring on more deflationary pressures. Post-recovery, the evidence points to more normal inflationary levels, again holding all else equal.

NOTES 1 M2 money supply is the total of money — in the form of in circulation, demand deposits, and that can be quickly converted into cash — that is available in the U.S. economy. M2 is a closely-monitored indicator of money supply as well as future inflation and used by the to adjust . M1 includes cash as well as checking deposits, whereas M2 includes M1 plus deposits, other time deposits, and money securities. 2 Core PCE represents inflation in the form of personal consumption expenditures excluding food and energy prices. Used as the key inflation metric by the Federal Reserve, it removes the volatility from movements in food and energy to provide more reliable underlying inflation trends. 3 The velocity of money represents the rate that money is exchanged in the economy as well as the amount of GDP generated for every dollar spent. It is calculated as the GDP in billions of dollars divided by the M2 money supply in billions of dollars. If velocity rises, larger and more transactions are happening between participants in the economy. Conversely, if velocity falls, smaller and fewer transactions are happening between participants in the economy. 4 Presently, consensus expectations are for the Fed to taper its bond purchases and to hike rates only when the economy has fully recovered back to normal, likely beyond 2021 as part of concluding the monetary stimulus that has been necessary during the pandemic.

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