Inflation, Consumption and the Economic Recovery
With gold near its all-time highs and the USD at its weakest level in more than two years, it’s reasonable to think that inflation could be a growing concern. The rise in money supply has significantly increased demand for precious metals, which we discussed in Currencies and Commodities. But all the liquidity pumped into the market isn’t circulating quickly through the economy with consumers and businesses saving more due to COVID uncertainty. For inflation risk to tick up, we need consumer demand to rise, as we outlined in Our New World: Is it Inflation, Deflation or Something Else? In line with this, we do not expect inflation to be a major concern in the near term. Rather, we believe that the recent uptick in inflation expectations is an encouraging sign of economic improvement.
• The current low velocity of money reduces inflation risk.
• Increased saving puts downward pressure on the velocity of money.
• The consumption story is evolving with the expectation of recovery. Currently, income insecurity and virus fears detract from spending on discretionary services.
• Inflation rising slightly is an encouraging sign of economic improvement.
The Low Velocity of Money Tamps Down Inflation Risk
Throughout history, money supply has been closely watched to understand both currency and inflation risks. Chart 1 shows the sharp increase in the U.S. money supply in response to the global pandemic. In July, U.S. M2 money supply, which includes cash, checking deposits and funds that are easily convertible into cash, increased 23.3% year over year (y/y) to $18,259.60 billion. It was the largest increase in money supply on record, significantly higher than its 6.8% long-term average.
But growth in money supply does not provide a complete picture for inflation risk. Velocity of money, which measures the turnover of money in circulation, is an essential component, too. In an environment where demand for goods and services is high, money circulates quickly. When that happens, the Federal Reserve (Fed) must be cautious about increasing money supply. The inflationary 1970s and 1990s are cautionary tales.
Conversely, in an environment where consumers and businesses hoard cash, the velocity of money is low. When that happens, increasing the money supply has a limited impact on inflation due to the higher supply of money being circulated at a far slower rate. Thus, it requires a larger increase in money supply. Chart 1 also shows the sharp decline in the velocity of money since the start of the pandemic. The decline is the continuation of a long-term, post-Financial Crisis trend.
Savings Good for the Individual, but Not Always the Economy
Someone saving for a rainy day is a good thing. However, when everyone increases their savings at the same time, it can have a large adverse impact on consumption and economic output and demand. The velocity of money is closely related to savings. Historically, there is a negative 51.5% correlation between the quarterly velocity of money and personal savings as a percentage of disposable income in the U.S. When the country spends more and saves less, the velocity of money increases. Conversely, when consumers protect their finances or work to restore them, like in the aftermath of the Financial Crisis, savings rates increase.
Chart 2 shows savings peaked at 33.5% of disposable income in April before steadily improving to 19% in June. The COVID lockdowns had a negative effect on consumer spending and business investment while encouraging saving. In line with this, U.S. GDP contracted at an annualized 32.9% in Q2 after declining 5% in Q1.
Several factors affected those savings figures, notably the changing composition of personal disposable income and consumer expenditure over the last year. Chart 3 shows personal income rose 14.6% in April when the CARES Act went into effect and people received their relief payments. But in May and June, personal income declined due to lower levels of pandemic-related assistance. Personal income is likely to decline even further from here unless Congress can reach a compromise on additional unemployment benefits.
On the expenditure side of the equation, both goods and services declined 12.5% in April following a 6.6% decline in March.1 Since then, spending on durable and non-durable goods basically returned to their pre-pandemic levels. This rebound provided some support for consumer spending; however, services are a larger portion of consumption in the U.S. and the COVID lockdowns had a far greater impact on services. Typically, services account for around 69% of personal consumption expenditure (PCE), but in Q2 declined to only 66.6% of PCE.2
Demand has improved, though. Looking at monthly spending as a proportion of disposable income, services declined from 61.2% before the pandemic to a low of 43.2% in April, before recovering to 51.5% in June.3 July could be a different story, as the national increase in COVID cases potentially reduced consumer appetite, especially in the regions affected the most by the spike in cases. The services segments that are most at risk are related to recreational activities, restaurants, travel, hotels and transportation. Importantly, these segments provide a large number of lower-skilled jobs and are thus critical to the economic recovery.
The Cost of Uncertainty is Reduced Discretionary Spending and a Delayed Recovery
Of the 22.2 million job lost between February and April, 81.5% were related to services. More than half of these job losses related to leisure, hospitality and retail. Thus far, about 40% of March and April’s job losses have been recovered. So, while there has been progress, the jobs market has not contributed to anything resembling a V-shaped economic recovery.
While the Paycheck Protection Program (PPP) helped, unfortunately the jobs outlook remains unclear as the virus drags on. In the original bill, to qualify for the loan becoming a grant, at least 75% of the money businesses borrowed had to be spent on worker retention over an eight-week period. The rules have been updated to 60% over a two-year period. However, the majority of the companies participating in the PPP took out loans under the old rules and spent the money before their business could get back up and running.4 As a result, many companies now need to furlough employees again.5
Combine this job insecurity with the lack of visibility on unemployment benefits and it’s obvious why consumers may be more cautious with their money. Adding to their stress is the expiry of the CARES Act’s additional $600 per week unemployment benefit and the moratorium on evictions.
Trump signed four executive orders aimed at filling some of these gaps, but their efficacy is questionable. For example, the executive order for $400 a week of enhanced unemployment benefits, if implementable, could take weeks to distribute, at best. It requires states to opt in, doesn’t provide any benefit to those receiving less than $100 a week state unemployment benefit and could be contested legally.6 7 Another executive order considers extending the moratorium on evictions, but it leaves the Department of Health and Human Services and the Centers for Disease Control and Prevention to determine to make the call.
The bottom line is that as announced, the executive orders do not provide any surety of income or protection for those most affected by the pandemic. Another round of impactful COVID relief likely requires Congress to go back to the negotiating table and get a deal done, which likely will not occur until September.
Some Encouraging Signs of Life for Demand and the Economy
Inflation’s steady improvement from its low of 0.1% in May is encouraging.8 Annual consumer price inflation (CPI) increased 1.0% in July. Volatile items such as food and energy played a large role in the increase. After bottoming in May, energy prices are higher, but remain well below last year’s levels. While overall inflation risk remains subdued, some prices increased.
Getting back to the basics of life; food, water and shelter. While the economy is making progress at reopening, people are still spending a greater proportion of time at home. Consequently, these key categories will increase in priority and thus inflation within these spending areas are likely to increase the perception of inflation risk. Referring to chart 5, it is encouraging to note that food inflation is starting to stabilize – coming off its pandemic high. Additionally, since the start of the pandemic, price increases for shelter became more subdued.
Core CPI, which excludes volatile items such as food and energy, increased to 1.6% y/y in July from its nine-year low of 1.2% that it hit in May. The improvement is generally viewed as a positive sign for the economy as prices are potentially starting to stabilize following the initial economic shock the virus caused. Chart 6 shows that inflation expectations are recovering as the economic reopening progresses. Implied or breakeven inflation and five-year forward inflation expectations have started to rise, but remain well below the 2% inflation target. Typically, the implied inflation and five-year forward inflation expectations are leading inflation indicators. As a result, we expect CPI to rise slightly over the coming months.
Conclusion: Deflation Risk Held at Bay
Apart from food, shelter and medical costs, inflation has been subdued to even deflationary since the start of the COVID crisis. A crisis like this illustrates why expectations for declining prices can be difficult for the economy to overcome. When consumers think prices will be lower next month or the month after, they’re more likely to delay purchases. The lack of incentive to buy puts further downward pressure on prices. So prices starting to rise somewhat is a step in the right direction for the economy.
Pockets of inflation risk remain, as the table below shows. However, at this stage of the economic recovery, we do not believe that inflation risk is a major concern. Demand for discretionary goods and especially services will remain tepid as long as virus fears and uncertainty linger. Until the consumer story improves, the velocity of money is likely to remain weak and keep a cap on inflation risks.