Steve Hanke: Inflation Will Hit Again Sooner Than Markets Expect

Key Concepts

Quantity Theory of Money: The fundamental principle that the money supply directly influences nominal GDP, which comprises real economic growth and inflation.
M2 Money Supply: A broad measure of money supply that includes currency, demand deposits, savings deposits, and money market mutual funds.
Nominal GDP: The total value of goods and services produced in an economy, measured at current prices.
Real GDP: The total value of goods and services produced in an economy, adjusted for inflation.
Federal Funds Rate: The target rate that the Federal Reserve sets for overnight lending between banks.
Quantitative Tightening (QT): The process by which a central bank reduces the size of its balance sheet by selling assets or allowing them to mature without reinvestment, thereby decreasing the money supply.
Supplemental Liquidity Ratio: A regulatory requirement for commercial banks to hold a certain amount of liquid assets.
Fiscal Deficit: The difference between government spending and government revenue in a given period.
Monetization of Debt: The process by which a central bank purchases government debt, effectively increasing the money supply to finance government deficits.
K-Shaped Recovery: An economic recovery where different segments of the economy experience vastly different outcomes, with some sectors booming (upper income) and others declining (lower income).
Inflation Tax: An implicit tax on individuals and businesses caused by the erosion of purchasing power due to inflation.
Regime Uncertainty: A state of uncertainty characterized by significant and unpredictable changes in the rules of the economic and political system.
Bubble Detector: A tool or metric used to identify potential asset bubbles.
Hard Assets: Tangible assets such as gold, silver, and real estate, often considered a hedge against inflation.
Stablecoins: Cryptocurrencies designed to maintain a stable value, often pegged to a fiat currency or other asset.

Outlook for Monetary Policy and Inflation

Global Economic Uncertainty and the Money Supply

Professor Steven Hanky begins by characterizing the global economy, particularly the United States, as uncertain and somewhat mysterious. He emphasizes the importance of analyzing the money supply using the quantity theory of money as the most effective method for forecasting nominal GDP. Currently, the M2 money supply has been accelerating after a contraction from 2022, growing at an annual rate of approximately 4.5%. While this is below Hanky's "golden growth rate" of 6% (which he associates with a 2% inflation target), he expresses concern that the money supply might accelerate further, leading to potential problems.

The Federal Reserve's Data Dependency and Policy Dilemma

The upcoming Federal Open Market Committee (FOMC) meeting on December 10th is a focal point. Hanky notes that the market's expectations for a 25-basis point rate cut are fluctuating. He attributes this uncertainty to the Federal Reserve's reliance on daily and weekly data ("data dependency") rather than a robust economic model or the quantity theory of money, which he states the Fed "pooh-poohs."

The Fed faces a dilemma:

Weakening Labor Market Data: Suggests a rate cut.
Stronger Inflation and Retail Sales Data: Suggests holding rates steady.

This constant flux in data leads to indecision and market jitters. Hanky argues that the Fed should focus on the money supply, which is the primary driver of the economy.

Factors Driving Potential Money Supply Acceleration

Hanky identifies four key factors that could lead to an acceleration in the money supply and, consequently, inflation:

Pressure to Lower the Fed Funds Rate: Political pressure from the President to reduce the Fed funds rate to 1% is a contributing factor.
Termination of Quantitative Tightening (QT): Starting in December, QT will cease. Currently, QT has a negative contribution to the money supply. Ending it will loosen monetary policy.
Changes in Bank Regulations: The lifting of the supplemental liquidity ratio for commercial banks will significantly increase their capacity to make loans, which is the primary mechanism for money creation (80% of M2 is created by commercial banks). This change is estimated to release approximately $2.6 trillion.
Large Fiscal Deficit and Monetization of Debt: The Treasury is issuing a substantial amount of short-term Treasury bills (less than one year duration). These are being absorbed by money market funds, effectively monetizing the deficit and adding to the money supply growth.

With the exception of the Fed funds rate, the other three factors are clearly pushing towards monetary loosening, suggesting faster money supply growth and, with a lag, increased inflation.

The K-Shaped Economy and Inflation's Impact

Hanky elaborates on the "K-shaped recovery," where the upper income bracket is booming due to asset price inflation (stocks, land, real estate, commodities) fueled by the Fed's aggressive money supply expansion during COVID-19. The wealthy, who own these assets, have seen their net worth surge (billionaire wealth as a percentage of GDP increased from 14.1% in January 2020 to 22.7% currently). This segment accounts for 50% of U.S. consumption, driving strong retail sales.

Conversely, the lower and middle-income brackets are experiencing declining real incomes because wages do not keep pace with inflation. This bifurcation is evident in public frustration over affordability, a significant theme in recent elections. Hanky argues that this income inequality was a direct consequence of monetary policy. He advocates for monetary policy to be "neutral," not distorting economic activity or wealth distribution.

Asset Bubbles and Market Risks

Hanky believes the current market is in a bubble, as indicated by his "Dr. X's bubble detector" and other metrics. He is uncertain whether the bubble will pop suddenly or deflate gradually. If the Fed loosens monetary policy, it could further inflate the bubble.

The Bond Market:

The Treasury aims to keep the 10-year yield around 4%.
However, the Treasury is issuing a disproportionate amount of short-term bills, which are being bought by money market funds and banks. This process monetizes the debt and increases the money supply.
Hanky explains the two-step process of monetary policy: initially, lowering the Fed funds rate leads to lower interest rates. However, with a lag, inflation kicks in, causing long-term rates (like the 10-year yield) to rise. He questions the Treasury's ability to keep the 10-year yield at 4% under these conditions.

Protecting Against Inflation

Given the risks of inflation and a potentially bubbly equity market, Hanky suggests gold as a strong hedge. He notes that gold has reached all-time highs and anticipates it could reach $6,000 an ounce by the end of its secular bull market due to inflation risks and broader geopolitical and economic uncertainties.

The Role of AI and Potential Bubble Pop Scenarios

Hanky expresses concern about the massive capital allocation into Artificial Intelligence (AI), with many startups lacking viable business models. He believes most will fail, with only a few large players benefiting. This misallocation of capital could be a factor in popping the market bubble.

Regime Uncertainty and its Economic Impact

Hanky distinguishes between normal uncertainty and regime uncertainty. He likens the current situation to the New Deal era, where unpredictable policy changes created significant uncertainty that prolonged the Great Depression by stifling private investment. He notes that while private investment hasn't completely stopped (e.g., in AI), the current regime uncertainty, driven by factors like tariffs and frequent policy shifts, makes economic analysis and forecasting more challenging.

Taxes, Deficits, and Inflation as Solutions

Regarding the affordability issue and potential future tax policies, Hanky believes that the affordability problem will persist due to inflation. He outlines three ways governments typically address deficits:

Reducing Government Spending: He deems this unlikely due to bipartisan disinterest in cutting spending.
Raising Taxes: He sees this as difficult to implement.
Inflation: Hanky identifies inflation as the "inflation tax," a phantom tax that erodes purchasing power. He believes this is the most likely path to address the debt and deficit, putting pressure on the monetary system to monetize debt and create excessive money supply growth, leading to inflation.

Crypto and Stablecoins

Hanky is skeptical of Bitcoin as a store of value or a solution to inflation, viewing it primarily as a speculative asset with limited use value, mainly for criminal activity.

However, he acknowledges that stablecoins backed 100% by Treasury bills can increase demand for U.S. dollar-denominated assets and act as a clone of the dollar. He stresses that stablecoin tokens are not legal tender and lack currency status, cautioning against viewing the crypto space as a "secular religion."

Investment Advice for 2026

Hanky's primary advice for investors looking towards 2026 is to rebalance their portfolios. He notes that a typical 60% stock/40% bond portfolio from January 2020 is likely now heavily skewed towards equities (e.g., 85% stocks). He advises against trying to time the market by getting out and back in, as this strategy has historically been disastrous. He emphasizes that investing is highly individual and depends on personal balance sheets, ages, and objectives, making sweeping general advice difficult. He reiterates the importance of focusing on fundamentals and the quantity theory of money to understand economic trends.