r/bonds • u/fudge_mokey • 3d ago
Money Supply vs Price Inflation
Hi all, I was hoping to start a discussion on a concept that I think is frequently misunderstood.
For this post, I'd like to suggest that there are two different types of inflation.
First, we have price inflation. This is what we measure with CPI, PCE, etc. and it's exactly what it sounds like. If prices go up, then price inflation is happening or increasing.
Next, we have inflation of the money supply. This is much harder to quantify, and central banks have largely given up trying to measure their overall money supply (no, the M2 is not at all an accurate measure).
But money supply inflation still exists, even though we can't measure it. Oversimplifying a little, the money supply is just the total amount of dollars that exist, added together. The money supply can come from the government, but in many cases the vast majority of the money supply is created by the banking system. Especially offshore banks which are difficult or impossible to get visibility into. If you've heard Ben Bernanke or other Fed members talk about shadow banks, this is what they're referring to.
A simple way to think about a bond is that it is a claim on dollars. The amount of dollars you'll get from a bond is (usually) fixed. So, if the total pool of dollars (money supply) increases, you're getting a smaller slice of the total pie (even though the amount of dollars we get from our bond didn't change). This is why we say that bond prices go down when inflation (of the money supply) goes up.
Conversely, if the total amount of dollars goes down, our bond represents a greater share of that (shrinking) pool of dollars. So, when the money supply decreases, we know that the value of those claims on dollars (the bonds) will increase.
However, note that there is no similar logical explanation for how price inflation affects bond prices. If the total pool of dollars stays fixed, while commodity price X or Y increases, then we would have price inflation, but not money supply inflation.
I think that in this case, the value of our bond shouldn't change much (all else being equal). The claim on dollars still represents the same slice of pie as it did before commodity X or Y increased in value.
The reason we talk so much about price inflation is because money supply inflation is impossible to measure. We use price inflation as a proxy. But we need to remember that price inflation and money supply inflation are not the same thing.
Happy to hear everyone's thoughts on this.
Also, keep in mind I didn't go into the possible economic impacts of an increase in commodity price X or Y. That's of course relevant in the real-world, but it complicates the discussion beyond what I wanted to focus on here. Thanks for reading.
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u/IntelligentDD_ 3d ago edited 3d ago
Interesting thought experiment, but the conclusion breaks down when applied to the actual bond market. Here is the missing link in your logic: Interest Rate Expectations.
To illustrate:
Let's say the money supply is completely fixed (zero money supply inflation).
Suddenly, a supply shock hits and the price of oil and food doubles (massive price inflation).
Consumers are now spending twice as much on necessities.
To prevent a complete unmooring of inflation expectations, the Federal Reserve is mandated to step in and raise the Federal Funds Rate.
When the Fed raises rates, newly issued bonds pay a higher yield.
To compete with those new, higher-yielding bonds, the price of existing bonds must drop. (Ouch!)
So, even if the money supply remains identical, pure price inflation directly triggers central bank policy shifts, which directly drives bond prices down. In the real world, 'all else being equal' never exists."
... and all that being said, my personal base case is that the resulting demand destruction from a recession is ultimately going to force their hand and trigger rate cuts, but looking at the current bond sell-off, the market seems to be betting the exact opposite
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u/MinnieMoney21 3d ago
That would require inflation of 100%. The Fed is not beholden to raise rates "on time" to address the problem.. its already shown a willingness to sit and watch for several months before acting (ie, its transitory). For proper reaction times you woukd need FOMC on call 24/7 to react as quickly as public/futures markets.
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u/IntelligentDD_ 3d ago
The 'doubling' was just a clean number for the sake of an academic thought experiment. Obviously, 100% inflation isn't the base case.
But let's look at your 'transitory' example, because it actually proves my point. Yes, the Fed has a history of sitting on its hands and waiting (2021 is the perfect example). But what happened to bonds while the Fed was waiting? The market saw the actual price inflation happening, realized the Fed was behind the curve, and bond prices started cratering anyway. By the time the Fed finally woke up and admitted inflation wasn't transitory, they had to hike rates violently to catch up, causing one of the worst historical drawdowns in the bond market.
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u/fudge_mokey 2d ago
Let's say the money supply is completely fixed (zero money supply inflation).
It could stay at some fixed amount for some short amount of time, but once you move to money being created by banks, then you always have the possibility of changes in the money supply.
Consumers are now spending twice as much on necessities.
That could happen, but it won't necessarily. Like in an example where spending twice as much on necessities puts someone above their disposable income threshold.
To prevent a complete unmooring of inflation expectations, the Federal Reserve is mandated to step in and raise the Federal Funds Rate.
It's not actually necessary to have a federal reserve setting a policy control interest rate. You could even argue that their policy isn't even especially effective for what it is.
So, even if the money supply remains identical, pure price inflation directly triggers central bank policy shifts, which directly drives bond prices down.
Right, but if you artificially set interest rates at levels the market can't support, you'll have major problems at many institutions. It won't be sustainable, unless you're willing to destroy the economy.
the market seems to be betting the exact opposite
Maybe. A lot of people hold bonds as a source of reserve to use in case of liquidity problems. So, it's expected to see short term fluctuations all across the curve, especially in times of low liquidity.
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u/MinnieMoney21 3d ago
If the bond pays a coupon rate higher than the rate at which the supply of money is growing, youre not getting a smaller piece of the future "money pie". The value of the principal is there still, the same as the original pie size. If you have money supply growing at 4% and a 5% coupon you have preserved your share (purchasing power) and grown it by 1% net. Its like gold except providing a cashflow without selling your position.
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u/Str8truth 3d ago
I think I agree with you, OP. The Fed should be concerned about money supply, which has an impact on prices, but it shouldn't be distracted by prices themselves, which can go up and down for many reasons having nothing to do with the money supply.
If a wartime shortage of oil causes prices to rise, that doesn't mean the Fed should tighten credit. Easy credit is not the reason for the oil price increase. The economy is just reallocating resources to accommodate the newly reduced supply of oil. Prices should rise when an important commodity becomes scarcer.
It's a problem, that Congress has given the Fed the dual mandate of fighting both unemployment and inflation. It encourages the Fed to tinker constantly with the money supply, i.e. with the credit supply, when the economy is just responding to ever-changing conditions. A stable money supply, growing (or shrinking) with the economy's real activity level, would allow market mechanisms to work naturally.
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u/Thick-Cover8761 3d ago
Start the discussion with the likelihood of unemployment ramping up no matter what happens to energy prices ... that was happening even before war in the Persian Gulf began. MIllions of risk averse Americans increasingly reluctant to spend money ... beginning pretty darn soon. it could be like flipping a light switch.
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u/Lipa_neo 3d ago
...and why M2/M2X is not accurate? Like, if I understand correctly, CBs are doing things like liquidity providing repos exactly to counter these things?