Something will cause inflation to go up this year, but it’s not oil

Key point: large M2 expansions—U.S. M2 averaged ~12.5% (Jul 1971–Jun 1973) and ~11.2% (Jan 1976–Dec 1978); Japan saw M2 at ~25.2% (Jun 1971–Jun 1973) then cut to ~12.8% (Jan 1976–Dec 1978)—preceded the 1970s/80s inflation spikes, with U.S. CPI rising from 3.7% (Jan 1973) to 12.3% (Dec 1974) and Japan’s CPI jumping to 23.2% in 1974. The author argues oil price shocks change relative prices but do not by themselves raise overall inflation; only accelerating money growth does. Implication for portfolios: if current U.S. deficits are financed through banks/money markets and broad money accelerates, expect higher headline inflation; controlling broad money growth should restrain inflation even if oil prices rise.

Analysis

Elevated oil prices act like a large negative shock to real incomes in the near term, but the market’s bigger inflection point is whether fiscal financing passes through into bank reserves and broad money growth over the next 3–12 months. If primary dealers and MMFs absorb incremental Treasury issuance without reserve expansion, the shock stays distributional (winners in energy, losers in discretionary consumption); if banks and nonbank money funds monetize deficits, expect a sustained repricing of nominal yields, breakevens, and commodity real returns.

Second‑order sector effects matter: rapid reserve-driven money growth would compress real yields and lift real assets (commodities, real estate, inflation‑linked debt) while benefiting large integrated energy names that hedge refining margins and return capital; conversely, a purely relative oil shock without broad money expansion favors hyper‑cash‑generative E&P names in the short run but penalizes consumer cyclicals and airlines. Currency flows amplify these channels — commodity FX (CAD, NOK) and EM FX should outperform a non‑sterilized USD if monetization accelerates, but underperform if the USD rallies on safe‑haven flows amid geopolitical escalation.

Timing is binary and fast: watch weekly Fed funds and reserve balances for a break above recent trend and monthly M2 prints for a persistent >3pp lift vs 6‑month trend; these are 1–3 month leading indicators for breakeven and TIPS outperformance. Policy reversal or aggressive Fed hiking (driven by headline CPI surprises) is the primary path to unwind the inflation‑on‑money thesis and would favor long nominal yields and short real‑rate steepeners.

Key Decisions for Investors

• Buy 5–10yr TIPS (or TIP ETF) via a laddered position sized to 3–5% NAV if M2 Y/Y rises by >3 percentage points over a 3‑month rolling window; reward: protection and convex upside to breakevens if monetization occurs. Risk: Fed hikes push real yields higher — hedge with a small short 2yr nominal futures position.
• Relative value: Long XOM or CVX (40–60% of an energy allocation) vs short LUV or AAL airlines (equal notional) for 3–9 months. Mechanism: capture upstream/refining margin resilience and downstream cost pass‑through; downside if jet fuel hedges or demand destruction is worse than expected.
• FX pair: Long CAD/USD or NOK/USD via forwards for 3–12 months conditioned on Treasury issuance being absorbed by domestic non-foreign investors (watch Fed reserve stats). Reward: commodity linkage and yield differential if USD weakens with money growth. Risk: USD safe‑haven rally on geopolitical escalation — size at <2% NAV.
• Inflation‑breakeven trade: Buy 10yr breakeven via TIPS or receiver 10yr inflation swap if monthly M2 > trend for two consecutive prints; alternatively, sell breakevens if Fed front‑loads hikes after CPI surprise. Position cap: 2–4% NAV given rate risk asymmetry.
• Short consumer discretionary staples with high fuel elasticity (select retailers/auto suppliers) for 3–6 months on any sustained oil rally absent money growth — enter if retail sales or PCE services show two consecutive monthly declines; hedge beta with SPX put protection to limit drawdown from market rallies.