We at Alaric Securities always try to go beyond the obvious and explore seeing things differently. Our new series, Market Insights, aims to give you another point of view based on pure statistics.

Enjoy the reading, and we wish you profitable trading!

November 8, 2022 | Issue 2

US Inflation in 2023 at 1.3%?
Is the FED Wrong Again

Nikolay Stoykov
Managing Director at Alaric Securities
  • For the third consecutive time, Federal Reserve officials raised the interest rates by 75 basis points to fight the persisting inflation. It has reached its highest level since the 1980s.
  • Agencies’ predictions for the following year’s inflation differ between 2.8% and 3.5%. The FED is targeting 2%.

You may have heard that the Fed met last week and raised the interest rate by 75bps. If you invest or trade actively, you not only heard about this event but may have also read the statement and even watched the press conference later on. Reading the statement and watching the press conference afterward is a good habit. You probably do that to get a better sense of what is going to happen. And you may even have a sense of what is going to happen – the headline on the subject the next day was “No Pivot, No Pause”…Understandably, you may be one of the people that have concluded that “Obviously, the Fed will continue to raise rates.”

Longer-term inflation expectations appear to remain well anchored … But that is not grounds for complacency, with inflation having run well above our goal for some time.

Jerome Powell, Chair of the Federal Reserve

What history says

“Not so fast”, we will say. Many of you do not remember that time, but in November 2004, Chairman Greenspan famously said, “Investors not hedged against inflation are desirous of losing money.”

Wonder what happened to those unhedged investors? They WON and won big time!

Let us give you another example with another FED authority – Chairman Bernanke, who said in the spring of 2007, “rising defaults in the subprime mortgage market will not have a serious impact on the economy.” Maybe not right away, but eventually.

Wonder what happened to the investors that listened to him? They LOST!

They got “taken to the cleaners” is a better description of what happened to them. The truth is that making ANY investment decisions based on what somebody else says is a recipe for disaster.

What we know – money supply, velocity of money, and GDP

Let’s start with what we know – inflation is a function of the total money supply, velocity of money, and GDP. Let’s examine those relationships on an annual basis for the last 20 years:

Year Inflation M2 Vel. of M2 Total Supply GDP  TS as % GDP
2002 1,59% 5772,0 1,927 11122,6 10936 101,7%
2003 2,27% 6067,3 1,940 11770,6 11458 102,7%
2004 2,68% 6418,3 1,958 12567,0 12214 102,9%
2005 3,39% 6681,9 2,001 13370,5 13037 102,6%
2006 3,23% 7071,6 1,997 14122,0 13815 102,2%
2007 2,85% 7471,6 1,977 14771,4 14452 102,2%
2008 3,84% 8192,1 1,813 14852,3 14713 100,9%
2009 0,36% 8496,0 1,726 14664,1 14449 101,5%
2010 1,64% 8801,8 1,745 15359,1 14992 102,4%
2011 3,16% 9660,1 1,648 15919,8 15543 102,4%
2012 2,07% 10459,7 1,586 16589,1 16197 102,4%
2013 1,46% 11028,8 1,560 17204,9 16785 102,5%
2014 1,62% 11681,5 1,537 17954,5 17527 102,4%
2015 0,12% 12344,0 1,493 18429,6 18238 101,1%
2016 1,26% 13209,6 1,441 19035,0 18745 101,5%
2017 2,13% 13852,3 1,440 19947,3 19543 102,1%
2018 2,44% 14358,8 1,458 20935,1 20612 101,6%
2019 1,81% 15319,1 1,425 21829,7 21433 101,9%
2020 1,23% 19124,7 1,146 21916,9 20893 104,9%
2021 4,70% 21490,0 1,142 24541,6 22996 106,7%
2022 8,20% 21503,4 1,189 25567,5 25248 101,3%

note: Total Supply = M2 * Velocity of M2

We are aware that people hate complicated charts. And you can study it in detail.

We just needed to post the numbers so you could see where they come from. And you should concentrate on just a few rows from it:

Year Inflation  TS/ GDP TS/GDP – 100%
2002 1,59% 101,7% 1,7%
2003 2,27% 102,7% 2,7%
2004 2,68% 102,9% 2,9%
2005 3,39% 102,6% 2,6%
2006 3,23% 102,2% 2,2%
2007 2,85% 102,2% 2,2%
2008 3,84% 100,9% 0,9%
2009 0,36% 101,5% 1,5%
2010 1,64% 102,4% 2,4%
2011 3,16% 102,4% 2,4%
2012 2,07% 102,4% 2,4%
2013 1,46% 102,5% 2,5%
2014 1,62% 102,4% 2,4%
2015 0,12% 101,1% 1,1%
2016 1,26% 101,5% 1,5%
2017 2,13% 102,1% 2,1%
2018 2,44% 101,6% 1,6%
2019 1,81% 101,9% 1,9%
2020 1,23% 104,9% 4,9%
2021 4,70% 106,7% 6,7%
2022 8,20% 101,3% 1,3%

A correlation between Total Supply/Nominal GDP and inflation

Those numbers suggest that most of the inflation in ANY given year can be explained by the last year’s Total Supply/Nominal GDP – 100%. For example, TS/GDP in 2002 was 101.7% – expected inflation was to be 1,7% vs. actual 2,27% in 2003. I

You are going to say – but this does not consider rising or falling interest rates and many other factors. And you will be correct, but practically all the time, the best models for predicting the future are based on relatively few and, most often, even one variable as long as they are uncorrelated variables.

It is imperative to state that this is NOT something that will happen but CAN happen if those historical relationships stay.

Key Takeaway

Anyway, we will save you the rest of the math and give you the statistics. On average, the model predicts the following year’s inflation pretty well – only a 0,09% difference between expected vs. actual (20 observations) with a standard deviation of 0,90%.

So, using this model, we can say that inflation in 2023 will be -0,50% to 3,1% with 95% confidence.

Do we have 95% confidence in that range – No, but we are confident that inflation expectations for 2023 are THROUGH the roof, and most likely, due to the hawkish policy, it will be relatively close to 1,3% and certainly nothing like the numbers we have seen this year.

How confident do we feel about this analysis then? Confident enough to feel extra comfortable with allocating towards fixed income products. In our opinion, this is one of the best opportunities in that sector for the last 20 years.

Sources:

United States GDP – https://tradingeconomics.com/united-states/gdp
Velocity of M2 Money Stock (M2V) – https://fred.stlouisfed.org/series/M2V
M2 and Components – https://fred.stlouisfed.org/series/M2SL

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