Inflation outlook for 2021

Here we go again, first of all I wish you a happy new year and a healthy and hopefully successful 2021!

In the first article of 2021 I collected some great charts about the correlation between growing money supply and inflation.

We all know the phrase "Never fight momentum". But let's be honest it's quite more than a simple phrase and everyone who says different is currently proven wrong by the market developments through the past year. But we also have to admit that we are currently living in challenging or at least undiscovered times.

There is so much and so sustainable kind of fiscal and monetary stimulus which backs the economy and within that also of course the market and that aid will be also provided through 2021.

That's in my opinion the main reason why since march 2020 it was easy for almost everyone to make money in the stock or bond market. True to the motto, no matter what you buy, it will increase in value because the liquidity will find its way into the market.

The big unknown factor will be the the influence from all that stimulus on the inflation outcome. And in the case of higher inflation (let's say more than the long term target of 2-2,5%) the appropriate answer by the FED.

It is no secret that the FED already signaled their full support through the year 2021.

This statement was made by FED chair Jerome Powell himself. One could argue that this fact alone could make additional help packages less effective, if they would be needed in the future, because the market participants already price in the full support.

Because what can the FED possibly do more than what they're doing right now. Another question is also whether the balance sheet of the FED does matter anymore and if not which implications such a declaration would have.

A whole other story is the fiscal policy site. There we'll see the Ex FED chair Janet Yellen in charge for financial decisions, as treasury secretary. And here I see room for more aid. Depending on the outcome of the Georgia runoff on January 5th and a possible tie in the senate, which could be broken by the additional vote of the Vice-President Kamala Harris, there could be room for much more financial help and even bigger packages than we saw in 2020.

But for now let's focus on the liquidity which was already added into the economy.

In 2020 we had two developments that couldn't be more different.

On the one hand, consumption was artificially restricted by the Covid19 restrictions, which also meant that the average consumer prices fell and there also was some kind of deflationary evidence in some quarters.

On the other hand, we saw huge growth in money supply, which exceeded everything we have known so far and, in an economic sense, is more likely to have an inflationary effect.

So kind of an opposite behavior, which should favor the CPI development through 2021.

As you probably already noticed, this is a very long-term view on the correlation between M2 money growth and GNP inflation in the US. To underpin this thesis, see this working paper, published by the ECB in 2008.

Here we have another graphic, where you can see that the money supply growth is leading 32 months, before the inflation rate in the US picks up speed.

To put a short timeframe up front I want to show you the following graphic by Bloomberg. Here they show the correlation between year to year M2 money supply, CPI and commodity prices. (in form of the Bloomberg Commodity Index)

source: bloomberg

Recently in an interview, the value investor legend himself, Charlie Munger, was asked about the huge stimulus in form of large QE and huge fiscal deficit. He answered that this was probably the most interesting question anybody could ask and we're in very uncharted waters. Nobody has gotten by with the amount of money we're printing right now (and will at least over the year 2021) over this kind of extended period, without some trouble. (what he means is surging inflation data)

It will be interesting to observe what happens this time with an amount of liquidity which we have never seen before in the US. Do we see real asset induced inflation, which we generally speaking saw since after the decade of The Great Inflation in the 70s, or does the CPI pick up on speed and implicated with that thesis commodity prices, like for example gold, grains and even oil. 2021 will be the year of the question about inflation.