“When the facts change, I change my mind.  What do you do, sir?”– John Maynard Keynes, British Economist, and pioneer of Keynesian economics.

Until recently, I’ve been an optimist about the direction and impacts of inflation. But two things have caused me to shift my thinking – at least for the near to moderate term. First, the war in Ukraine. Second, the money supply continues to expand at a concerning pace.

Though shifting, the consensus view still seems to be that inflation should subside by year-end as the economy continues to open and supply chain and labor issues resolve. The Fed believes it will be back to near 2% inflation in a couple of years. There is now enough evidence to question this view. Sustained inflation, or perhaps even worse “stagflation” ala 2020’s style, looks like the more probable near-term direction.

Where is Inflation Coming From?

As noted in my last post, inflation is coming from three distinct places: fiscal “stimulus” funds, monetary policy (interest rates and the money supply), and Covid-induced shortages of labor and supply chain disruptions. The consensus view that inflation will moderate goes like this: the fiscal stimulus funds and giveaways are mostly completed[1], the Fed is tightening monetary policy, and the Covid-induced shortages will resolve as we go through the year. Fingers crossed, but I’ve grown skeptical.

We might be mostly complete with the fiscal giveaways, but that money remains in the system (and it’s not all spent, yet). The supply chain problems will eventually resolve – but pessimism is starting to set in around this issue for a timely resolution,[2] and the Ukraine war will pile on here.

The labor issues continue, and there doesn’t seem to be clear answers as to what is causing the labor participation rate to remain stubbornly low. The data is indicating early retirements, relocation to low-cost areas to work remote, fear of catching Covid at work, effects of long-haul Covid, Covid mandates, and daycare issues. In the 1970’s, we had stagflation coupled with a high unemployment rate. It’s easy to imagine that a continued tight labor market could create even more inflationary pressures should we experience stagflation now.


The war in Ukraine is clearly affecting energy markets – this is obvious at the gas pump. In addition, Russia and Ukraine are major producers and exporters of grain.[3] Russia is also a major exporter of fertilizer.[4] Expect more pain at the grocery store as food prices rise due to lower yields/supply. And that’s probably just the beginning of markets becoming distorted due to the war. China was already putting pressure on grains prior to the war as they try to rebuild their pig population after African swine fever. In addition, supply chains are being cut in the seas around Ukraine as insurance companies suspend coverage on shipping in these war zones. So in addition to sanctions, the private market acted quickly to cut off supply routes.[5] Western governments undoubtedly will be reviewing their defense budgets, and Europe is now facing difficult decisions on energy. None of this is a positive for inflation.

Money Supply

Adherents of the economist Milton Friedman are called monetarists. Monetarists believe that the money supply directly impacts inflation. As more money is created by the Federal Reserve and the banks, then inflation goes higher (if it’s not offset by real growth). The Federal Reserve, in contrast, doesn’t believe that the money supply is relevant in measuring inflation anymore. According to Jerome Powell, the head of the Federal Reserve, he believes that the link between the money supply and inflation was broken forty years ago.[6] So who’s correct? Given the imprecise nature of economics, it’s hard to say, but the evidence lately has been favoring the monetarists.

The chart below shows the money supply exploding once Covid struck and is continuing to advance 13% per year – it was growing around 6% per year pre-Covid. And the concerning problem is that inflation’s impact on an economy tends to lag the money supply by about 12 to 18 months.

Where Does Money Come From?

Two places: the Federal Reserve and banks. The Fed has been periodically buying massive amounts of bonds beginning with quantitative easing in 2009 (QE for short). QE was originally invoked as an emergency measure back then. But under Ben Bernanke, QE was resurrected as another monetary tool to boost the economy. QE sounds confusing, but it’s rather straight forward. The Fed buys government bonds from private market participants by “keystroking” money into existence (i.e., printing it). This cash infusion into the economy increases the money supply. Money needs to go somewhere, and now we have large amounts of money chasing limited supply and investment opportunities. This is a bit simplified, but you get the idea. The Fed currently has around $9 trillion (that’s a T) of bonds on its balance sheet.[7]

Banks also create money. Let’s say you deposit $100 in your bank account. The bank, of course, wants to make money on your $100. Let’s say they loan $90 to another customer and keep $10 in reserves. The bank just created money…$90 of it. That $90 is then spent into the economy or deposited in another bank (for further loans to be made).

To deter lending (and suppressing the money supply), the Federal Reserve might increase interest rates (reducing people’s willingness to borrow), sell government bonds to the banks (this soaks up excess funds that banks could otherwise loan), require the banks to keep more money in reserves (less money to loan), or pay the bank a higher interest rate to keep funds at the Fed (at some point, the bank will decide that holding funds at the Fed, risk-free, is better than loaning the funds to the public and taking on the risk of the loan not being repaid). So far, the Fed hasn’t done much.

What is the Fed Doing to Combat Inflation?

The Fed just raised short-term interest rates .25% and last November they began reducing the amount of bonds they are buying. But this might not be enough, and the Ukraine War has just complicated their job. If the Fed tightens monetary conditions too much in an inflationary economy awash with money, then we might be rolling out the term “stagflation” – low or even negative real growth with persistently high inflation. Further, a recession later this year or next cannot be ruled out if the Fed feels it must act aggressively to control inflation. But the Fed will be hesitant to act aggressively in an election year. The Fed is theoretically independent, but they don’t want to be blamed for election results.

Sheesh, Is There Any Good News Out There?

Yes, there is. Companies are aggressively investing and adopting technology to improve productivity.[8] Higher productivity is an absolute good in society. It raises our standard of living by contributing real, meaningful growth to an economy while raising wages for workers without contributing to inflation.

According to the St. Louis Federal Reserve, bank lending does not appear excessive[9] while the “velocity of money” is subdued.[10]  Velocity of money is the rate at which money is exchanged in an economy. If these measures remain stable, then that should help contain inflation. Monetarists believe that a higher velocity of money leads to inflation, so even if the expansion of the money supply begins to contract, velocity could pick up as the economy fully reopens thereby prolonging or worsening inflation.

Fourth quarter earnings reports were outstanding, and analyst estimates remain strong for 2022 and 2023.[11]  Excess money in the system should be a tailwind for stocks and support stock prices as we move through the year.

Lastly, if we go into recession, then we do. Capitalism has always been a relentlessly effective system that washes away excesses that result from poor government and private market decisions. Everything resets, stocks are “returned to their rightful owners”, and we start over. I still believe we remain in a long-term “secular” bull market, though, as always, things like geopolitical events could derail that.

Investing in an Inflationary World

While technology can be a powerful disinflationary force, it’s hard to see this force overcoming the severe shock of the Ukraine war to the world economy and the greatly expanded U.S. money supply.[12] If the monetarists are correct and the Fed is wrong on the money supply issue, then the Fed might be in process of committing the policy blunder of a generation.

Stocks generally do well in an inflationary environment, though they might struggle at first. But eventually, well-run companies can raise prices to keep up with inflation. An inflationary environment tends to favor solid companies that have a history of paying rising dividends. Government and high-quality corporate bonds struggle, but commodities generally perform well. Cash is a loser. Gold can also do well, but past results here are mixed. This new inflationary environment will cause investors to reexamine their assumptions, because investments tend to perform very differently across various levels of inflation.

We will remain well-diversified, but there is enough evidence that we should blend in additional defensive measures against inflation. I have added some exposure to commodities, energy, agriculture, utilities, natural resources, and metals in portfolios. I have also added more exposure to companies that have a consistent history of paying rising dividends. And it seemed prudent to add some focus to cyber security firms.

Inflation is deeply destabilizing to economies and always hurts the lower economic classes most. Let’s hope our leaders question all assumptions as they make decisions that affect the lives of so many Americans. And our thoughts and prayers go out to the people of Ukraine and Russia.

It can be difficult to stay invested, and the events of the last couple of years are testing us. As always, we deeply appreciate your continued confidence and trust. Please stay patient, stay disciplined, and stay invested.

[1] CNBC, 12/09/2021. But there remains plenty more to spend. In addition, the $1 trillion infrastructure bill has yet to be spent.
[2] New York Times, 02/01/2022.
[3] Wikipedia, data is for 2020 wheat exports.
[4] World’s Top Exports, 03/08/2022.
[5] Reuters, 03/08/2022.
[6] Reuters, 02/23/2022 and https://www.youtube.com/watch?v=SGNyCOlIEHY.
[7] FRED Economic Data, 03/16/2022.
[8] Bloomberg, 09/11/2021
[9] FRED Economic Data, 03/11/2022.
[10] FRED Economic Data, 02/24/2022
[11] Yardeni Research Inc, 03/14/2022.
[12] Barron’s, 02/04/2022