“Asset inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
—Milton Friedman (with Asset added)
Since the Greenspan era, the Fed’s response to financial and/or economic shocks has been to flood the system with liquidity in order to dramatically loosen financial conditions. This serves to not only stabilize financial markets but also buys the real economy time to heal. Unfortunately, over the past 30 years the real economy has required increasingly larger amounts of money supply and liquidity to generate a similar amount of both nominal and real economic growth.
- The long-term development and challenge brought into full relief by the global pandemic along with the theory that over the past 30 years the main impact of money supply growth has been asset inflation.
- The challenges the market will soon encounter when money supply growth dwindles to a more normalized level over the next 12–18 months as the Fed readjusts policy away from the emergency response of the pandemic.
The palliative impact of massive money supply growth since the dark days of the pandemic-driven bear market has been debated and discussed at length over the past 18 months, particularly how over $5.3 trillion in M2 growth combined with almost $6 trillion in fiscal stimulus drove asset prices higher, mitigated the depth of the economic downturn and supercharged the economic recovery. However, despite the unprecedented magnitude of both fiscal and monetary stimulus, the outcome from another round of money supply growth was just the continuation of a long-term trend in Fed policy: As economic or market shock transpires, the Fed cranks up the printing presses, asset prices reflate while real and nominal economic growth lag. For market participants, these actions have been referred to as Fed Chair puts: first Greenspan, then Bernanke, then Yellen, and now Powell. Ultimately, excess liquidity does not lead to lasting economic growth but instead drives further asset inflation.
The reasons behind this phenomenon are complex and include a steady reduction in monetary velocity, the ratio of bank loans to deposits, increasing levels of income inequality (affluent individuals tend to invest more of their money in stocks, real estate and fine art than mechanics, miners or waitresses), as well as post-great financial crisis (GFC) bank regulatory reform. However, the trend is undeniable. The U.S. economy has required a greater and greater increase in money supply to generate the same unit of nominal and real economic growth. Instead of excess money supply showing up as real economic growth, it is trapped in capital markets and generates continued asset inflation.