Why inflation stays stubbornly high
Inflation Update
Last week we received two updated inflation readings. The consumer price index is stubbornly holding steady at slightly over 3% year-over-year. Please see the chart immediately below.
Meanwhile, the more volatile producer price index (commodities) is trending higher. See the image immediately below. What are we to make of these readings? Foremost, the inflation fight is not over and so long as readings come in higher than the Fed’s 2% inflation target, we see no potential for a change to the Fed’s interest rate policies.
Why is this happening? We believe that the lack of progress reducing inflation is related to money supply. Here is a picture of the year-over-year changes in money supply as measured by M2:
So if we are right and money supply dynamics are driving inflation dynamics, what is causing the money supply to grow? We know the Fed is keeping interest rate tight, and the Fed is continuing to shrink its balance sheet, both of which are restrictive policies, so it is not Fed policy. We think the culprit is government deficit spending.
Federal government year-over-year expenditures grew by the following percentages in each quarter of 2023: 1) 11.95%, 2) 7.38%, 3) 12.52%, and 4) 5.50%. Given that government expenditures represent a full third of GDP and the private sector continues to grow in spite of restrictive Fed policies, we think government expenditures are a likely reason no progress is being made on the inflation front. We’ve got the Fed doing one thing and our elected officials are doing the opposite!
The bottom line is that it is very hard for the Fed to bring inflation down when government expenditures are growing at these year-over-year rates. Federal expenditures are simply out of sync with Fed policy. Our view is that this dynamic will persist, which leads us to conclude the Fed is going to continue to stay “higher for longer” with respect to its rate policies. We will hear from the Fed this week, and this is basically what we expect them to say.