Has the Inflation Demon Been Slayed?

The Federal Reserve would sure like us to think so, but evidence is beginning to build that it might be harder to achieve and maintain 2% inflation than the Fed would like.

The late, great economist, Milton Freidman, said many times that only government creates inflation (link) and the reason is that only government can print money. Friedman believed that inflation is caused by a rapid increase in the money supply relative to the production of goods and services, in other words, too much money chasing too few goods.

Core inflation, that is, ex-food and energy, is running about 3.3% year over year. The Fed expects (hopes?) that it will continue to trend down toward the 2% target, but there are some burgeoning reasons to question that, and it all has to do with money.

The chart below is the year over year percent change in the Money Supply (red line), the core Producer Price Index (blue line), and the core consumer price index (green line). What becomes apparent in the chart is that as Freidman believed, inflation was presaged by a rapid growth in the money supply (M2) in response to COVID. That growth peaked in February of 2021.

The connection to be made here is that the growth in producer prices, the prices at which businesses sell their products or services to other businesses, followed the rise of the money supply and peaked in March of 2022. Consumer price growth, the last leg of the value chain, peaked in September 2022.

Now, we see the situation reversing. The money supply growth bottomed in April of 2023 (and turned positive a year later). Producer price growth bottomed in December of 2023, and by all appearances, consumer price growth bottomed in September of 2024.

We believe that one of the main reasons that U.S. economic growth has remained solid is the continuation of extraordinary fiscal deficits. In the first two months of fiscal 2025, the deficit was a record $624 billion. The calendar pulled some December payments into November, which makes this number appear higher than on an apples-to-apples basis, but the conclusion is unaltered – as a country, we continue to borrow and spend.

In our view, the Fed needs to be careful about rate cuts. Their position is that current interest rates are restrictive and therefore can, and need to, come down. The problem is that continued GDP growth is contradictory to that conclusion. The pace of fiscal spending appears sufficient to be offset the restrictive nature of interest rates.

The risk is that the Fed continues to lower interest rates; deficits continue, and inflation gets kicked into a higher gear once again. The chart appears to make that case very clearly.

A rate cut in December is baked-in, but come 2025, decisions to lower rates further should be more difficult to make. If rates don’t fall as expected, or even begin to rise in anticipation of higher inflation, then there are growing risks to the stock market already at high valuations. This bull isn’t dead yet, but inflation may not be dead either. We have been watching out for the potential for growing inflation fears, which would likely drive long term interest rates even higher. This uncertainty regarding the path and volatility of long-term interest rates was one of the reasons we eliminated or hedged our longer-term fixed income holdings.

We would guess that it will take a 10-year Treasury rate of 4.75% to 5% to cause meaningful problems for the equity market. The recent softness in equities has no doubt been partially a result of this concern. For perspective, the 10-year US Treasury closed Friday at a roughly 4.40% yield, up o.25% for the week.

Eyes to the skies this week. Something is up there…

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All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current accuracy, reliability, or completeness of, nor liability for, decisions based on such information, and it should not be relied on as such.

The views expressed in this commentary are subject to change based on the market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance, and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.

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Only Government Creates Inflation – Milton Friedman

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By: Adam