A Conversation With Michael Ashton, the “Inflation Guy” (October 8, 2023)

From money velocity to trade and fiscal deficits, Ashton lays out why inflation will remain elevated

By Lisa Beilfuss
October 8, 2023

Where the U.S. economy and financial markets go from here hinges in large part on inflation. For each economist expecting ongoing disinflation, it seems another predicts sticky price inflation that may keep interest rates higher for longer and continue to erode Americans’ purchasing power.

Michael Ashton is one of this writer’s favorite sources to call about inflation. Known as the “Inflation Guy” on his blog and podcast, Ashton is the founder of Enduring Investments LLC, a consulting and investment management boutique focused on inflation. 

Ashton is a pioneer in inflation markets. He traded the first interbank U.S. inflation swaps, which are used by market participants to hedge inflation risk and to speculate on the course of inflation. He has worked in research and trading for several investment banks including Natixis, J.P. Morgan, Deutsche Bank and Barclays. 

This week, Praxis spoke with Ashton at length. Here is an edited Q&A of the conversation.

Praxis:
The Federal Reserve’s latest projections show central bankers expect inflation to fall to their annual 2% target by the end of 2026. Is that realistic?

Michael Ashton:
Inflation is coming down, and we all agree on that. The question is the destination. I differ from a lot of mainstream economists in that I don't think there's any natural reason that inflation will fall back to 2%. I think that we're going to end up with core [where food and energy prices are excluded] and median inflation in the high 3s to low 4s, and that it's going to be very difficult to get inflation persistently below that.

What are the biggest implications for investors if inflation rises 3%, instead of 2%, annually for an extended period?
There are at least two big implications. One of them is that the level of market volatility is going to be higher. Historically, when you have higher inflation, the volatility of equity prices is higher and the volatility of bond prices is higher. Over the last 20 years, we’ve gotten used to pretty docile financial markets. When the stock market goes down 1%, it used to be a fairly standard day. Now it's a headline. We're going to go back to periods of lots more choppiness.

The other implication is important for investors but one that I think many people miss. When you have inflation of about 3% or higher for at least three years, stocks and bonds become correlated. We're so used to the idea that having a 60% stock and 40% bond portfolio is lower risk because they move in opposite directions. But that has only been true for the last 20 years of low inflation.

When people are concerned about inflation, it is inflation–not growth–that drives the value of stocks and bonds. While growth has the opposite effect on stocks and bonds, inflation affects stocks and bonds in similar ways. With stocks and bonds correlated, and amid higher market volatility, it means the amount of risk you have to take for a given level of return is going to be higher. It’s going to take people a while to adjust back to that reality. As for commodities, they will remain a portfolio diversifier.

What is the biggest risk to your call that inflation will remain higher for longer?
We could get back to the 2% target if the Fed continues to shrink its balance sheet for a considerably longer period than people think they will, though we would still have trouble maintaining inflation at that rate. If the Fed keeps doing what they're doing, then, we might be back to something fairly normal in 2025. By “fairly normal,” we’re talking about 3% being the average around what we fluctuate–not 2%. 

How likely is the Fed to continue quantitative tightening (QT), or the reversal of quantitative easing (QE), to shrink its balance sheet? One problem is that normally when the Fed is tightening, they generally have had a strong economy and so there really isn’t a question about which part of their mandate [inflation or employment] is more important. It will be more difficult to continue shrinking the balance sheet when the economy is contracting.

What are the odds the Fed doesn’t just end QT early but conducts QE before reaching its inflation target?
I would assess it as a lower probability than I would have a year ago. I put the odds at maybe 20%--fairly low, but still way higher than it should be. 

The Powell Fed has raised rates far more than I ever thought they would, and far more than a Yellen Fed or a Bernanke Fed or a Greenspan Fed would have. Now this Fed has been tightening amid robust economic growth, so it hasn’t been that big a challenge, but it still has been a change in the demeanor of the Fed from the prior quarter century. 

But at some point, if interest rates start spiking and you believe that one of the Fed’s goals is to help keep the economy from crashing, then their dual mandate of price stability and maximum employment will conflict. My guess is that they would try to walk some middle ground, meaning they wouldn’t grow their balance sheet as much as they have previously. 

Why do you expect inflation to remain elevated?
A lot of the stuff that was pushing inflation lower over the past 25 years is now pushing inflation higher. 

There is deglobalization. From the fall of the Berlin Wall until roughly Brexit and the election of Donald Trump, we had globalization and we were exporting production to lower and lower cost centers around the world. And so we had this “globalization dividend,” where we got a much better mix of growth and inflation for a given level of money supply growth. That has all stopped, even reversed, as Covid emphasized the costs of long supply chains and higher interest rates made long supply chains more expensive. And of course there's plenty of political tension around the world.

Globalization may have been holding down inflation by at least half a percentage point. And now it is pushing inflation up by that much. An upshot: for a given level of money supply growth we’re going to get a bad mix of growth and inflation–meaning lower growth and higher inflation.  

There is also the problem of the developed world’s aging workforce. We have a decline in the growth rate of labor supply, and in a lot of cases an outright decrease in the labor supply. 

And then there is the fact that we still have quite a bit of remaining momentum from the initial rise in the money supply. [M2 increased 40% during the pandemic]. Money supply is now contracting, but money velocity is coming back. And so there's still quite a bit of upward momentum there, and that's the reason that inflation hasn't come down faster.  

The renewed rise in money velocity isn't getting much attention. Why does money velocity matter?
You can think about the pressure on prices as the product of the quantity of money in the system times how often each dollar is spent. If you have lots more dollars, then that can cause pressure on output and lead to inflation. Or if you have the same number of dollars but spend them lots more, it has the same effect.

Typically the main driver of money velocity over long periods of time is interest rates. Higher interest rates mean higher money velocity. And so one of the things that I had been saying–long before Covid, even–was that eventually you'll get this vicious cycle where higher inflation causes higher interest rates and higher interest rates cause higher money velocity, which causes higher inflation. I didn't realize it would happen quite this fast. But one of the perils of having interest rates go back up to the norm is you'll have velocity eventually go back up to the norm.

Why is money velocity an underappreciated inflation risk?
When the Fed and the federal government flushed lots of money into the system during Covid, money supply shot up while money velocity crashed because a lot of that money flew into bank accounts. People just couldn't spend it quickly enough. There was also an element of precaution–consumers wanted to hang onto their money longer. And so a lot of people thought, okay, money velocity will stay down even when money supply growth goes down. But that's not how it works.

It’s sort of like you have a car attached to a trailer with a spring. Money velocity is the spring. As the car goes speeding away, initially the spring stretches out as the trailer starts moving. But eventually the spring compresses and the trailer catches up with the car. That's what we're seeing right now. 

The monetary issue we have here is that velocity was kind of a one-way street for a generation, as interest rates were a one-way street lower. As rates go back up, so does money velocity. And so just like we had this virtuous cycle from the early 1980s until the late 2010s, we're now in the phase now where we're going to a vicious cycle. Higher velocity is going to keep inflation higher than it otherwise would be, which keeps interest rates higher than they otherwise would be, which keeps money velocity high, and so on. This is part of why I don't think we're going to get inflation back to 2%.

How high will money velocity go, in turn undermining improvement in inflation?
The initial stop would be where we were prior to Covid. Before the pandemic, the velocity of M2 money supply was 1.4. [Calculated as the ratio of quarterly nominal GDP to the quarterly average of M2 money stock]. It got as low as 1.1 and has so far recovered to 1.3. So there is still another roughly 7% just to get back to that level.  

But if you look at where money velocity was when interest rates were last here at this level, it is more like 1.6 or 1.7. What that means is that even if the Fed is successful in continuing to shrink its balance sheet and the money supply just goes flat for years, we're still going to have inflation coming from velocity rebounding. People will spend the same number of dollars, they'll just gradually spend it more and more quickly.

Would a recession short circuit the money velocity that you see in the pipeline?
Velocity is the inverse of the demand for cash. The two things that drive money velocity in the long run are interest rates–the main factor–and precautionary demand. When interest rates are really low, people hold more cash because they don't earn much interest on investments. They also tend to hold more cash when they’re scared, such as during a downturn. 

If interest rates fall quite a bit with a recession, then you might have money velocity go back down to where it was at the beginning of 2020 but not all the way back to where it was in early 2000, when rates were last around current levels. But the flipside is that a deep recession, the same one that would result in lower rates, might spur renewed money supply growth if the Fed conducts another round of quantitative easing. 

If quantitative tightening is the primary way to shrink the money supply and it ends prematurely, will the focus on reining in fiscal spending become sharper?
To get inflation, you either need crazy money supply growth or you need a lot of money supply growth and expansionary fiscal policy. Similarly, to get inflation back down, you either need very tight monetary policy or somewhat tight monetary policy and somewhat tight fiscal policy. 

It would be good for a lot of reasons to have smaller deficits. Among other things, a federal government running very large deficits creates a potential need for the central bank to buy some of the debt issued to fund the spending so that interest rates don't spiral out of control. 

We may be seeing some of that now. Rates are around fair value after years of being too low. But if rates continue to rise in a sloppy way, and the government is running multi-trillion dollar deficits, at some point the Fed is going to be expected to come in and keep interest rates from spiraling higher. The only way they can do that is by buying long bonds. That would mean the Fed is effectively monetizing the U.S. debt, meaning that money printing is financing the deficit.

So for all the debate around who will be the new marginal buyer of Treasuries, will it inevitably be the Fed?
Ultimately the Fed becomes the buyer of last resort.

If you have a large trade deficit alongside a large federal deficit, that's kind of okay because you're sending all these dollars overseas. Foreigners have to buy something with those dollars, and they buy the additional Treasury supply issued to fund the deficit spending. It's a nice closed loop.

But if you're going to have a lower trade deficit–a result of deglobalization–and you also have a large federal deficit, then somebody's got to make up the difference and buy those bonds. A smaller trade deficit means that the marginal buyer won’t be foreign buyers.   

Maybe we'll get control of the deficit. The interest cost of the debt is starting to go up really fast. I would say that’s the biggest disaster risk if we don't get control of the deficit really quickly. Then there is no easy way out. The Fed will end up having to buy as a stop gap, and that leads to more inflation.