In a recent debate with Michael Pento, an intriguing argument was made that increases in money supply, federal deficits, and quantitative easing (QE) would lead to 1970s-style inflation. This perspective seems reinforced by the inflation spikes observed in 2021 and 2022. However, historical data suggests that these factors do not necessarily correlate with inflationary trends. This article delves into the nuanced relationship between monetary policy, fiscal deficits, and inflation, revealing why today's economic environment is markedly different from the past.

The misconception that rising money supply directly causes inflation stems from two flawed assumptions. First, it incorrectly assumes that the U.S. dollar has lost value relative to all other currencies due to increased money supply. Contrary to this belief, the trade-weighted value of the U.S. dollar has remained stable compared to its 1980 levels, despite significant growth in M2. In fact, increases in the rate of change of money supply have historically correlated with a stronger dollar, not a weaker one. Second, the argument overlooks the broader context of economic cycles. Historically, increases in the money supply have coincided with deflationary periods such as the Dot.com crash and the Financial Crisis, rather than causing inflation. Notably, the only exception was the unique circumstances of the COVID-19 pandemic, which temporarily disrupted supply-demand equilibrium.

The notion that government "money printing" leads to higher inflation is also a misinterpretation. In reality, all money is created through lending, not direct printing. When the government needs funds, it issues debt, which is purchased by primary dealers who provide capital. This process does not increase the money supply but rather shifts assets within the financial system. Consequently, the federal deficit, often cited as a cause of inflation, has had little impact on price levels. Since 1985, inflation has generally decreased while the federal deficit has grown, indicating that higher deficits are associated with slower economic activity and lower inflation. This inverse relationship underscores the deflationary nature of non-productive government spending.

Quantitative easing (QE) further complicates the inflation narrative. Contrary to popular belief, QE does not create new money but involves asset swaps between banks and the Federal Reserve. These swaps boost bank reserves without stimulating economic activity or increasing the money supply. As a result, despite multiple rounds of QE, inflation remained moderate around the Fed's 2% target until early 2020. The surge in inflation during 2020 was driven by extraordinary circumstances—specifically, the shutdown-induced supply constraints coupled with stimulus-driven demand surges. Once these temporary factors dissipated, inflation began to normalize.

Looking ahead, the long-term outlook points towards disinflation rather than renewed inflation. The ongoing accumulation of unproductive debt will likely exacerbate deflationary pressures and slow economic growth. Historical evidence shows that rising debt levels have consistently detracted from economic prosperity, necessitating continued government deficit spending to support social welfare systems. While another significant inflationary event cannot be ruled out, it would require a substantial disruption in supply and demand dynamics. For now, investors should remain vigilant about disinflationary risks, which can significantly impact earnings growth.