Recently, Steve and I were talking to one of the banks where we do business to see if we could improve the interest rate on one of our accounts, since right now, most money market accounts have super low rates below 0.5%.  Our banker attributes this to excess liquidity, which basically means: banks are sitting on more money than usual.

To better understand how this works and the impact it has on our chosen market — real estate — I asked our resident economic brainiac, Jim Dickson, for his take.  Jim always knows the recent data on these trends.  Here’s what he had to say about how this “excess liquidity” affects the economy:

As long as there is excess liquidity in the system, it’s kind of hard for there to be any sort of serious pricing correction or crash in the real estate market.  There is almost always a marginal buyer who would like to have pretty much any asset if it was priced just slightly lower at any point in time.  The big correction usually only comes once that marginal buyer, who would like to buy at a slightly discounted price, can’t buy because he doesn’t have access to capital.

All of this excess capital in the system is almost definitely going to be very inflationary.  And it’s not going to be “transitory” inflation that corrects itself after a short period like some people in the Fed have been recently claiming.  It’s going to be structural, monetary inflation like what we saw coming out of the 1940s (which we wrote about in our recent newsletter).  Below are the U.S. government interest rates going back to 1934.  The only other time that rates were kept so low for so long, like what we are currently experiencing, was in the 1930s and 1940s.

Click the graph to open it in a lightbox, or click here to download the full-size, zoomable image.

Below is the consumer price index (CPI) going back to 1914.  As you can see, there was crazy inflation (as high as almost 20%) coming out of the last extended period of near zero interest rates.

Click the graph to open it in a lightbox, or click here to download the full-size, zoomable image.

I have been anticipating a traditional market crash (where the price of everything goes down in dollar terms) for a long time now.  However, I am starting to become more and more convinced that the coming crash will be in the dollar itself It doesn’t take a ton of time for inflation to erode purchasing power in a big way.  If we do end up seeing 10% to 20% inflation like in the 1940s and 1950s, the price of hard assets like real estate could increase substantially in dollar terms–not necessarily because they are any more valuable or useful than before, but simply because the dollar is substantially less valuable than before.

Aside from low interest rates and an increasing monetary base, the other big factor that can cause inflationary pressure is when the velocity of money increases.  “Velocity of money” refers to the “measurement of the rate at which money is exchanged in an economy” (Investopedia).  There are two types of velocity, known as M1 or M2 money supply – the currency and assets in a country’s economy.  This gets somewhat technical, but you can learn more about this hereThe main point to know is that M2 velocity is currently extremely low.  Below are the historical rates going back to 1959 (I couldn’t get the data any further back than that to compare to the 30s and 40s, but it still gives us some historical context).

Click the graph to open it in a lightbox, or click here to download the full-size, zoomable image.

The historically low M2 velocity is a result of banks tightening up their lending standards due to all the uncertainties during COVID.  As soon as they are ready to start lending at a more traditional pace again, the money velocity will increase, and the bank multiplier effect will effectively increase the overall monetary base of dollars even more.  Here’s an example to demonstrate this:

Banks multiply money by lending it out.  Let’s imagine you and I both have an account at JP Morgan Chase and I want to send you $100.  I can initiate the transfer online and Chase will update both of our account balances without doing anything with the $100 in their vault.  Now you have $100 more than before, I have $100 less than before, but no change has been made to the total dollars in the system.

Now, let’s imagine a third person comes to the bank and asks the bank for a $100 loan.  Chase can give your $100 to this new person without making any adjustment to the total balance in your account.  You still have $100 to spend and now so does this new person.  The bank just created $100 out of thin air.  That’s the money multiplier effect.

And as of very recently, the banks have started to get more comfortable lending.  According to bank surveys, we appear to be in the early stages of loosening lending standards for commercial and industrial loans to large and middle-market firms. 

Click the graph to open it in a lightbox, or click here to download the full-size, zoomable image.

If we are about to enter a period of substantial inflation, we advise using it to your advantage, as we wrote about here.  The gist is that this is an excellent time to borrow, because the value of your loan will remain the same even as the value of the dollar changes.  Borrowers always seem to prevail coming out of periods of inflation because you have two options which can put you ahead of the curve:

  1. Borrowing to buy into real estate or another alternative form of investment which places your money into something tangible with long-term value and liquidity.
  2. Even better, if you’re borrowing (say, at 5%) and investing that money into something with a return rate that’s higher than your interest (like the Buy & Hold Fund at 8%, for example), you can find yourself making a profit while everyone else is scrambling to not go under with inflation.