Hope for the Best, Prepare for the Worst?

By: Andrew J. Willms

President and CEO of The Milwaukee Company

The U.S. Congress has to date passed four stimulus packages in its effort to limit the economic damage and personal hardship brought on by the Covid-19 pandemic. So far, the largest is the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which cost the Federal government an estimated $2.9 trillion -- the most expensive legislation of its kind in U.S. history.

USA Spending is the official open data source of federal spending information. It reports that as of September 1, 2020, the four stimulus programs have, in the aggregate, provided approximately $2.59 trillion of funding available to various federal agencies in connection with their efforts to respond to the Covid-19 pandemic. An additional $3.92 trillion has been appropriated to fund extensions of credit, business loans, and loan guarantee programs.

And yet, with all this deficit spending financed with newly printed dollars, we still have a very low rate of inflation. In an earlier article, which you can find here, I discussed the differing opinions as to whether inflation was forthcoming. Because of the importance of this topic to investors, I would like to elaborate on my earlier observations.

A fundamental principle of classical economics is that all else equal, value falls as supply increases. Accordingly, if the amount of dollars in circulation – the “monetary base” – increases, the value of the dollar should fall. [1]

Another tenant of classical economics is the law of supply and demand. As applied to currencies, it stands for the proposition that all else equal, if the amount of currency a nation has in circulation grows faster than its GDP, and as a result there is more money chasing the same number of goods, inflation will occur.

So why has inflation remained in check to date? The decline in demand that has resulted from the pandemic has offset the increase in monetary base. Rather than being spent, the new money is being deposited in bank accounts and invested in stocks and bonds.

There is plenty of data that supports the foregoing. The value of the dollar is in decline, consumer spending has dropped, bank deposits have risen, and the stock and bond markets have soared, notwithstanding the worst medical crisis in 100 years. In short, even though the monetary base has increased, the new dollars are not being spent on goods and services. As a result, inflation has been temporarily held in check. I say temporarily because if either GDP contracts further or consumer demand grows, then inflation could well be a major cause for concern.

U.S. GDP has grown at a record pace since the end of the national lockdown. And, it’s hard to envision consumer demand returning to more normal levels before Covid-19 is under control. Then again, tremendous progress is being made in treatment and vaccine development. These advances offer hope that we will turn the corner in 2021. If so, I would not be surprised to see the inflation rate surpass the Fed’s target rate of 2% before the end of next year. In my view, now is the time for investors to prepare for that possibility.

[1] Sure enough, the Invesco DB US Dollar Index Bullish (UUP), an ETF that tracks the dollar’s value relative to a basket of foreign currencies, has fallen from a recent high on March 24, 2020 of $102.94 to $25.37 on October 30, 2020. What makes UUP’s sell-off more surprising is that it defies the dollar’s historic status as a safe haven in times of a crisis.


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