Inflation: Is it Over? (No? But Also Maybe?)

For two days every August, the biggest nerds and ghouls and ghoulish nerds gather in Jackson, Wyoming. 

If you’ve never heard of Jackson, I’m not surprised. 

Nobody knows that this is the city where America’s wealthiest people hang out. 

Seriously. There are more billionaires and millionaires per capita there than any other city… 

The county has the highest average income of any county in the United States: $312,442. 75% of the earnings come from investments or other non-wage sources.

If you want to schmooze with the rich? Go to zip code 83014. 

But if you really want to touch the bishops’ robes of the elite puppeteers behind the U.S. financial system? 

Drop into the Jackson Hole resort in late August for the “Jackson Hole Economic Policy Symposium”... 

Where dozens of central bankers, policymakers, academics, and economists stop by every year to perform dark rituals in hooded robes while monks chant unholy verses. 

By “dark rituals,” I of course mean, like, discussing how the overvaluation of the Swiss franc exacerbates interest rate differentials. 

I’m not kidding. You can read every remark and every paper presented here. 

But this year, in 2022, all eyes were on this small, secluded, stupidly rich community for one reason… 

They wanted to hear what Federal Reserve chair Jerome Powell had to say about the economy, inflation, and interest rates. 

I’ll spare you the suspense. Here’s what he said (emphasis mine):

The Federal Open Market Committee's (FOMC) overarching focus right now is to bring inflation back down to our 2 percent goal. Price stability is the responsibility of the Federal Reserve and serves as the bedrock of our economy. Without price stability, the economy does not work for anyone. In particular, without price stability, we will not achieve a sustained period of strong labor market conditions that benefit all. The burdens of high inflation fall heaviest on those who are least able to bear them.

Restoring price stability will take some time and requires using our tools forcefully to bring demand and supply into better balance. Reducing inflation is likely to require a sustained period of below-trend growth. Moreover, there will very likely be some softening of labor market conditions. While higher interest rates, slower growth, and softer labor market conditions will bring down inflation, they will also bring some pain to households and businesses. These are the unfortunate costs of reducing inflation. But a failure to restore price stability would mean far greater pain.

Let me turn on my economic euphemism translator for you:

“Using our tools forcefully to bring demand and supply into better balance” means they have to quash consumer and business demand by any means necessary, since the Fed cannot fix supply issues. (The Fed, after all, can print money. Not factories.)

“A sustained period of below-trend growth” means the U.S. economy is going to grow slower than anyone expects, or go into a recession, for a long time. 

“There will very likely be some softening of labor market conditions” means, at worst, lots of folks are going to get fired from their job and, at minimum, you definitely shouldn’t expect a raise. 

“They will also bring some pain to households and businesses” means that regular people, investors, entrepreneurs, and business owners will be punished financially for things completely outside of their control. 

Basically, in clear terms, the Fed chair admitted that inflation is a huge problem.

To fix that problem, they will stop at nothing.

Because they will stop at nothing, this is likely going to cause a tremendous amount of economic damage, possibly including a recession. 

So… expect another interest rate hike on September 20 or 21. 

How did the market react to this news?

Well, as you can see in the chart below: Poorly. 

Oof. 

Looks like investors are in for a little bit more pain before this bear market goes away. 

Of course, that leaves a lot of folks wondering, quite rightly…

“If I have to bear all this economic pain due to inflation, when will inflation calm down in the U.S.?”

A few weeks ago, I began a deep dive explaining inflation. 

• I explained what inflation is as a concept (it’s weirder than you think!)...

• I showed examples of why, as an econometric measure, it is horrendously flawed…

• I also illustrated why high inflation absolutely killed growth stocks this year. 

I ended that piece promising to revisit an estimation I made in 2021 for the inflation we’d see in 2022…

And that I would make another estimation for the level of inflation we should expect to see in 2023. 

So allow me to keep my promise…

“Hello. My Name is Sean ‘Finance “Cassandra” Daddy’ MacIntyre.”

This is what I wrote in August 2022, when we first heard people starting to panic about a coming inflation storm: 

As of early July, 26% of Americans cited inflation as their biggest concern about the economy.

Yet Fed Chairman Jerome Powell and President Biden have been brushing concerns aside.

All this mixed messaging is confusing. So let’s answer the question:

What level of inflation should we reasonably expect in the future, based on everything we’re seeing?

If a cup of coffee costs $2.40 now, in August 2021, we want to predict what it will cost in August 2022, based simply on what we can see in the news and published government policies.

Now, economics isn’t an exact science. I’ll be making a lot of questionable assumptions.

That said, let’s have some fun... With charts and data!

First off, let’s look at the connection between money supply and inflation:

The orange line above is the CPI, which measures the average price of things in the U.S., like rent, utility bills, cigarettes, bacon, cars, etc.

(You can see a list of all the CPI items and how this figure is determined here.)

The blue line is the M2 money supply, which tabulates everything from the dollars in your wallet to the coins you have hidden in a jar, from your bank savings accounts to your mutual funds.

The correlation between M2 and CPI is 0.916. That means they’re nearly in lockstep with each other.

Meaning, when money gets printed, prices will go up.

We can plot that relationship this way to make some predictions:

Here’s what this chart is telling us…

If we add another $1 trillion to the U.S. money supply by this time next year…

We can reasonably expect to see CPI inflation go up about 9.2%.

That $2.40 cup of coffee will cost $2.62.

Let’s say we add $4.5 trillion to the U.S. money supply by this time next year…

We should expect to see CPI inflation go up about 12.8%.

The inflation rate released last month? It was 8.5%. 

Let’s chalk that up as an “I called it.” 

Or to quote Ian Malcolm in Jurassic Park:

“Boy, do I hate being right all the time.”

(I kid… I kid… I’m human and therefore often wrong.)

In August 2021, the money supply in the United States was $20.6 trillion. In August 2022, it was about $21.6 trillion. 

So M2 went up by close to $1 trillion. Pretty close to the low end of my hypothesis, which was based on a simple observation…

Back in the summer of 2021, Congress was literally talking about how much money they wanted to inject into the economy. 

Now, though, things are much more complex on the monetary policy side, which would muck up the model I used last year. 

For example, as I’m writing, the Fed is undergoing “Quantitative Tightening.” 

This is an experimental policy that’s never been done at this scale before. 

Basically, when the markets crashed, the Fed needed to step in and take assets from banks, so that banks would continue lending to consumers. 

This is called Quantitative Easing. 

The Fed still has all these assets, though.

So to tighten, the Fed will be selling these assets back to banks and institutions, as well as letting some of these assets — which are mostly bonds — expire. 

This will reduce the M2 money supply. 

However, at the same time, the U.S. government just approved a spate of spending bills and price freezes. 

Ironically, one of the biggest is called the “Inflation Reduction Act” — a sweeping health care, tax, and climate bill with $430 billion in new spending. 

If you just had the thought, “Wait, doesn’t extra spending potentially cause inflation?”

Your thought is correct. 

All these additional spending bills will increase M2. 

As you can see, right now, there are conflicting forces at work in the U.S. economy, each of which create both inflationary and deflationary pressure.

If we use the same formula from my original model, but simply add $500 billion to the U.S. money supply…

That predicts an annual inflation rate of 0.9% in August 2023. 

That’s pretty low. Lower than the 2% the Fed is targeting. 

The model suggests that, if all things hold steady over the next 12 months, the efforts in place to curb inflation will work. 

I wasn’t satisfied with this answer. 

Mainly, I wasn’t satisfied because we’re talking about economics. Nothing ever “holds steady” in an economy.

Also, it felt “too low,” considering all the other major issues going on in the economy right now — especially with spiking food and energy costs. 

So over the last two months, I’ve been rebuilding and refining the model — mainly for my other newsletters, which are now on sale here. 

Back to the Drawing Board

Here’s what I did…

I adapted a formula from Quantity Theory for what I call the P Factor, or “Pricing Factor.” 

The formula comes from a theory that was developed by Nicolaus Copernicus in 1517 and explored further by the economist Milton Friedman, in his book A Monetary History of the United States. 

There are more complex forms of it, but the simplest form of it is: MV/q = P

M = Money Supply (M2)
V = Velocity of Money
Q = The Real Economic Output of the Economy

Here’s what the P Factor formula tells us…

When there’s lots of money (M2) spreading around the economy quickly (v), but a country’s economic output (Real GDP) is lagging behind that money?

It creates inflationary pressure. The P Factor is higher, so inflation tends to climb higher. 

Now, when there’s not a lot of money, and it’s having a hard time spreading through the economy, but economic output is expanding?

It creates deflationary pressure. The P Factor is lower, so inflation tends to decrease. 

I use the word “pressure” for a reason — because the P Factor doesn’t create inflation, necessarily. A higher P Factor is more like a force that subtly influences people making pricing decisions.

You can see the relationship between the CPI and the P Factor in the chart below:

As you can see, the model maps pretty closely to reality — the observed CPI. This P Factor model correlates even closer to reality than my original model. 

So that means we can take this formula and make predictions about what CPI might be next year, based on what’s happening to the M2 money supply in the U.S.

We know that government spending is going to add close to $500 billion to M2, which pressures inflation to go higher. 

We know that the Fed is trying to sell or destroy some of its $8.5 trillion in assets, which subtracts from M2 and pressures inflation to go lower. 

So let’s use my P Factor model and we can see what can happen to the CPI over the next year, considering both of these additive and subtractive forces:

On the low end, if the Fed manages to shed trillions of dollars from its balance sheet over the next year, the annual inflation rate will be around 0% to 1.3% by August 2023. 

On the high end, if the U.S. economy simply sees money supply continue to increase with government spending as the Real GDP contracts due to a recession, we will likely see a 3.4% inflation rate by August 2023. 

This is pretty far below economist and consumer inflation expectations over the next year, which range from 5% to 6.22%. 

But if you take a weighted average of these two scenarios and also consider what might happen to the velocity of money if the U.S. goes into a recession…

You get a midline between these two extremes, which is my official prediction for what inflation will be in August 2023: between 2% and 3.2%. 

This is relatively close to what the market is betting inflation will fall to over the next 5 years — 2.27%. 

Mathematically, this prediction means CPI inflation is likely to hover around 8% for several months before it starts declining in October and November. 

And this fact poses a potential problem for investors…

The Trickery of Math and the Shortcomings of the Human Brain

Most people are notoriously, pathologically bad at understanding and contextualizing numbers. 

Like, really bad.

For the same reason that most people don’t realize that a 200% increase would triple a quantity, folks are going to wrongly assume that inflation numbers published by the media are still high… even if they’re trending down. 

I’ll prove it... 

It’s September 2 as I write this. The annual CPI inflation rate last reported was an eye-poppingly high 8.52%. 

Let’s say the CPI dropped by the most it has in 25 years: -1.77% in one month (recorded in November 2008, during one of the biggest stock market collapses in history). 

Guess what…

Even with that ENORMOUS one-month drop?

Inflation would still be an eye-poppingly high (((295.3*0.9823)-273.1)/273.1=) 6.2%. 

Because math!

Here’s one more fact I want to point out on the path to my main point…

What if inflation kept going up from here? What if the Fed, like, sorta fails and inflation keeps going up by its long term monthly average from this point? What would inflation be a year from now?

Well, if inflation kept climbing from here, inflation will be (((295.3*(1.002^12))-295.3)/295.3=) 2.4% in August 2023. 

A perfectly reasonable inflation rate, according to the Fed. Also very close to my prediction above.

So let’s lay out the three scenarios…

• Scenario 1: Inflation drops sharply, the yearly figure stays high for several more months (driving down Real GDP, sparking recession fears), people panic about it for the rest of 2022.

• Scenario 2: Inflation goes up at its average rate, the yearly figure stays high for several more months (driving down Real GDP, sparking recession fears), people panic about it for the rest of 2022.

• Scenario 3: Inflation goes up faster than average, the yearly figure stays high for several more months (driving down Real GDP, sparking recession fears), people panic about it for the rest of 2022.

Now… let’s look at this logically. 

In 2/3 of those scenarios… 66% of those possible cases… people will be responding irrationally to something they don’t understand…

Or rather, they’ll be responding irrationally to something they do not realize is being fixed!

Things will get worse before they get better. 

And in 1/3 of those scenarios? 

People will be responding rationally to a problem that has, in the U.S., never persisted for longer than a few years. 

Things will get worse before they get better. 

Unless you believe that we’re witnessing an America that’s unraveling at the seams…

It looks like the American economy and the stock market will be… 

Fine?

Yeah. Fine, in all likelihood. 

So let me reiterate that I’m not worried about inflation right now. I was worried about it in August 2021… which launched me on this whole “model building” enterprise.

If they’re smart, investors should begin preparing for a “post-inflation” or even potentially a “deflationary” stock market.

That makes growth stocks look exceptionally attractive right now…

Even if they were to go down further from here. 

So I’m going to begin updating the inflation report I prepared last year, which you can access for free on our member’s page. (NOTE: If you signed up for our emails, that doesn’t necessarily mean you’re a member yet! You still need to create a free account to get that content.)

I’ll be adding more information about assets that do well during inflationary as well as disinflationary times. 

But if you’re not interested in all that and you just want a ticker you can buy right now? 

Take a look at $QTEC.