At the height of the
stock panic in late November, the flagship S&P 500 stock index had
plunged 49% year-to-date. Fully 2/3rds of this decline happened in the 9
weeks leading into the panic lows! Naturally the psychological impact of such
an epic selloff was utterly massive. Fear exploded to unprecedented extremes.
A stock panic is a
bubble in fear, and succumbing to this overwhelming fear leads to irrational
selling near lows. But interestingly at the time, investors failed to recognize
this truth. They sold aggressively, and they wrongly assumed their selling
was rational. Of course the only thing that would warrant a 38% loss
in the stock markets in just over 2 months was a new depression. So
depression fears mushroomed.
With a depression
comes deflation, so deflationary theories became widely accepted in December
and January. Yet there was one big problem. Deflation is purely a monetary
phenomenon. If prices of anything are falling simply for their own intrinsic
supply-and-demand reasons, and not as a consequence of monetary contraction,
then it is not deflation. In reality, the money supply was skyrocketing in
the panic.
With the Fed ramping
the US dollar supply far faster than the pool of goods and services on which
to spend it, inflation was inevitable. Relatively more dollars bidding on
relatively fewer things means higher general prices, the formula is simple. I
wrote an essay on the big inflation coming in January, when deflation fears reigned supreme,
using the Fed's own data to highlight the staggering monetary growth.
Saying it was
inflation that was coming, not deflation, was extraordinarily controversial
just 5 months ago. You would not believe the firestorm of flak I weathered
for pointing out the threat of inflation. Being contrarian never wins
friends. But not surprisingly, today the consensus view on money is shifting
to an inflationary bias. With a more receptive audience not blinded by fear,
I thought I'd update this analysis.
Sadly inflation is
woefully misunderstood in popular culture. People tend to think it is simply
"rising prices", but this is incorrect. The formal dictionary
definition of this word is "a persistent, substantial rise in the
general level of prices related to an increase in the volume of money and
resulting in the loss of value of currency". The key is the rising
prices have to be driven by an increasing money supply.
Consider an example.
If the Fed doubles the money supply and hence gasoline prices ultimately
double, this is inflation. More dollars are bidding on the same amount of
gasoline, driving up its nominal price. But if some calamity takes Saudi Arabia
offline, and gasoline prices double, that has nothing to do with inflation. Supply
contracted sharply, demand remained constant, and hence prices rose. These
are two different scenarios leading to the same outcome, but only one is
inflation.
And the reality is
the prices of everything are derived from a complicated mix of the supply and
demand of any particular item and the supply and demand of money itself. So
usually a given price increase has a commodity supply-and-demand-driven
component as well as a separate money-driven component. This is why it is
notoriously hard to measure inflation and why average folks have a tough time
understanding it.
Since separating out
price effects is virtually impossible, it makes far more sense to look at the
cause of inflation. That is money supplies increasing at faster rates
than the underlying economy. If you think of price inflation as smoke, an
effect, then why not look for the fire that creates it, the cause? This fire
is excessive monetary expansion. When a fire initially flares brightly, there
might not be smoke right away. But there sure will be if it keeps burning!
Only a central bank
can directly affect the base money supply. Yes, commercial banks can expand
credit through fractional-reserve banking, but credit is not money. Credit is
just access to someone else's money. If I offered you a $100k check as a
gift, you'd be pretty excited. If I offered you this same $100k as a loan,
you wouldn't be. Money and credit are very different beasts, so don't make
the mistake of assuming credit contraction automatically means general
deflation.
The place to look
for coming inflation, the fire that is going to produce the smoke, is in the
Fed's own money-supply data. I'll start with a broad measure of the US money
supply, money of zero maturity. MZM is a liquid monetary measure that
includes all currency, checking accounts, savings accounts, and money-market
accounts redeemable on demand. It does not include CDs and other time
deposits.
This first chart
graphs the raw MZM data in yellow along with the absolute annual growth rate
of MZM in blue. For reference, the year-over-year growth rate in the Consumer
Price Index is also included. While the CPI is horribly flawed for a variety
of reasons, it remains the most widely accepted measure of inflation today. But
it ignores the cause, monetary growth, and tries to filter out effects,
rising prices.
The Fed, or any
central bank running a fiat currency not backed by gold, really only has one
single power. It can inflate. Inflation, growing the money supply, is the
Fed's response to everything. Sometimes it inflates more, sometimes
less, but it is almost always inflating. It is very rare to see money
supplies contract, and even in these isolated cases it is only for a trivial
amount over a very short period of time.
Back in the
mid-2000s, MZM growth was stable near CPI growth. In 2004 and 2005, YoY MZM
growth averaged 3.1% while YoY CPI growth averaged 3.0%. Also, note above
that prior to mid-2006 the CPI direction generally mirrored that of MZM
growth. If MZM growth rates were increasing, so were the CPI's. And vice
versa. But in 2006, a
couple major events sowed the seeds for the massive MZM/CPI disconnect we are
seeing today.
In early 2006, Ben
Bernanke took over the helm of the Fed. An academic, he had a long record of
being pro-inflation. He believes the Great Depression happened because there
wasn't enough inflation, so if he was ever thrust into a crisis he would ramp
the money supplies rapidly to try and avert it. Late in 2006, the CPI's
calculation methodology was changed. Rising prices would be more aggressively
edited out of this index so "inflation" would remain at
politically-acceptable levels for Washington.
Bernanke's mettle
was soon tested with the subprime mortgage crisis in early 2007, the general
credit crunch in late 2007, and the global stock selloff in early 2008. The
Fed's response was typical, it did the only thing it could do. It rapidly
increased the rates of monetary growth. Stable at 4% when Bernanke took
office, absolute annual MZM growth soon ballooned to 8%, 12%, even 16% in
early 2008! The Fed was flooding the system with new fiat dollars.
Thanks to the CPI's
methodology change, this surge in money was not being reflected in this
index. Yet choosing not to measure something properly does not mean it
doesn't exist. The surging MZM growth was readily apparent in commodities
prices. The basic raw materials are the first prices to be driven higher by
more money bidding on them, it takes time for these prices to flow through to
the finished goods the CPI measures. Of course commodities surged mightily in early 2008, partially as a result of this
inflation.
Even though the Fed
tried to rein in the MZM explosion of late 2007, it was soon confronted with
the stock panic. So it responded the only way it knows how to this new
crisis, again it flooded the system with more dollars created out of thin
air. And as you can see above in the yellow line, even though the stock panic
is long over the Fed hasn't even attempted to withdraw any of this inflation.
MZM remains near record highs!
Since the beginning
of 2008, absolute annual MZM growth on a weekly basis has averaged 12.9%! This
is a staggering expansion rate. Remember the old Rule of 72 from college
finance? At this 13% compounded growth rate something will double in 5.6
years or so. Indeed since Bernanke took over, MZM has ballooned by 40%. This
incredible deluge of money has to go somewhere.
Theoretically, if
money-supply growth didn't exceed underlying economic growth there wouldn't
be any inflation. This is why the gold standard is such a brilliant solution
to money. The natural mining rate of gold almost never exceeds the natural growth
rate in the global economy. But of course the US economy hasn't even come close
to growing 40% since early 2006 when Bernanke came to power or at a 13% rate
since early 2008.
In fact, per the US government's own GDP data, since early 2006
the US
economy has only grown 11.0%, a far cry from the 40.4% the Fed has grown MZM
over this span. And since early 2008, GDP is actually dead flat at 0.4% while
MZM money has soared 16.8%. In both cases the excesses are pure inflation,
new dollars created out of thin air that are now chasing a relatively smaller
pool of things. Higher general prices are the inevitable result.
And boy, if you exist
you know this! Over the past several years, have your costs of living risen
or fallen? Is your food at grocery stores and restaurants getting cheaper or
more expensive? Are your utilities bills and insurance costs rising or
falling? Do you feel like you have more disposable income after necessary
expenses or less? We all see this relentless and very real inflation no
matter what the government statisticians try to tell us. The nominal cost for
existence just keeps rising and rising thanks to the Fed.
Now if MZM has
averaged 13% annual growth since early 2008, then why has the CPI gone
negative? There are a couple reasons. First, the CPI is designed to
intentionally lowball inflation. Its custodians filter out rising prices and
overweight the rare falling ones, like computers. Washington wants a low CPI read because it
reduces non-discretionary government expenditures on welfare programs indexed
to the CPI. This gives politicians more money for their pet projects. Wall
Street wants a low CPI read because high inflation is bad for the stock markets.
But the primary
reason the CPI plummeted was due to the stock panic. If you don't remember
how scared people were in late November and early December, go back and read
the big newspapers from then at your local library. Thanks to sensationalist
mainstream-media coverage, average Americans really believed a new depression
was upon them. I've reported tons of hard stats on this in our subscription
newsletters since the panic. Americans radically reduced spending, hoarding
cash for the worst case.
Remember that the
prices of everything are a function of supply and demand. As demand for goods
plunged, desperate retailers cut prices to spur sales and clean out
inventories. It was this dynamic, a plunge in consumer demand, that drove the
falling consumer prices the government emphasized. General prices did not
decline because money shrunk. There never was any deflation despite the CPI!
If the raw
money-supply data isn't enough for you, consider the Continuous Commodity
Index. The CCI is an equally-weighted geometrically-averaged basket of 17 key
commodities. It bottomed in early December as the stock panic ended. Since
then, it has surged 31.3% higher. Now there is no way global commodities
demand grew by a third in just 6 months. The rise since the panic was driven
by a combination of investment demand as well as more dollars bidding on
commodities, inflation.
If I ended this
essay here, investors would have plenty of reasons to deploy capital in
investments like commodities that thrive in inflationary times. Our
subscribers have already earned big gains in this sector since the
panic. But amazingly, this high sustained MZM growth is minor compared to the
primary inflation threat. Even though it is going to drive huge gains in my
investments, this next chart really frightens me.
The narrowest
measure of money supply is known as the monetary base, or M0 (zero). M0 is
simply currency (paper dollars and coins) in circulation, currency in bank
vaults, and reserves commercial banks have on deposit with the Fed. M0 is
critical because it is the base of all money we use for daily transactions. It
is also the base from which fractional-reserve banking multiplies. M0 growth
has the most direct impact on inflation of all. Its raw numbers are shown in
red and its year-over-year growth rates in blue.
For 48 years prior
to the stock panic, absolute annual M0 growth averaged 6.0%. And this was
within a tight range that seldom exceeded 10%, and even then only for short
spells. Why? The Fed, at least before Bernanke, knew that excessive growth in
the monetary base would rapidly lead to price inflation. Growing M0 too fast
is playing with fire, very dangerous.
The only notable
event in M0 in a half century was the pre-Y2k ramp, a brief period of
15.8% growth ahead of the date rollover and all its big unknowns. Yet
Greenspan realized how dangerous this was, even for a crisis, so within a
year M0 was actually shrinking a bit as he tried to soak up all that excess
pre-Y2k liquidity. Interestingly, some economists believe this Y2k M0 ramp
helped drive the vertical final few months of the tech-stock bubble and that
the subsequent rapid slowing in M0 growth accelerated its bust.
M0 growth was
trending lower in 2008, averaging 1.2% in its first half. This is one of the
main reasons inflationary expectations were fairly low prior to the stock
panic despite the record commodities prices last summer. But then the stock
panic erupted and the Fed panicked, getting swept away in the fear. Bernanke
decided to inflate far faster than has ever been witnessed in the Fed's
entire history since 1913.
In October, the
scariest month of the panic when the S&P 500 plummeted 27% in less than 4
weeks, the Fed suddenly expanded the monetary base by $224b. This was a 25%
surge in a single month, just insane. And it led M0 to rocket to its
highest YoY growth rate ever by far, up 36.7%! But the Fed was just getting
started in its unprecedented inflationary campaign.
In November it grew
M0 by another 27% over the prior month, yielding 73.0% YoY growth. In
December it again grew M0 by 15% MoM leading to a mind-boggling 98.9% YoY
gain. In 4 short months, the Fed had literally doubled the US monetary
base! Something like this has never even come close to happening before, so
we are deep into uncharted inflation territory here.
By late December
this information slowly started to leak out and contrarians who have studied
monetary history were appalled. Was the Fed mad? Bernanke responded to these
growing criticisms in Congressional testimonies, promising that the Fed would
remove its "accommodation" (a euphemism for inflation) as soon as
possible. Even though the Fed has never shrunk the money supply
noticeably, Wall Street curiously took Bernanke at his word.
So every month since
the panic ended in mid-December, when the VXO fear gauge fell back out of
panic territory, I've been watching M0. In 3 of the 4 months since (May data
isn't out yet), the Fed has actually grown M0 further! In January, February,
March, and April, the absolute annual M0 growth rates weighed in at 106.0%,
88.5%, 97.9%, and 111.0%! And in April alone M0 surged to a new all-time
record high. And by late April the stock markets had already rallied 29%, yet
the Fed was still rapidly growing M0.
Friends, this data
is flabbergasting! How can the monetary base double in 4 months, and stay
doubled for almost 6 now, and have no impact on real prices? The monetary
base is our transactional cash we use to buy everything. Even checking
accounts are directly tied to it, although the mechanism is beyond the scope
of this essay. The Fed has not only failed to start contracting M0
post-panic, but it is still growing it.
Nothing like this
has ever happened before, not even in the 1970s during the last inflation
scare. So the inflationary impact of a doubling of narrow money in 4 months
will certainly be serious. Exacerbating this effect, as consumer spending
recovers and bids on now-depleted inventories of consumer goods, prices will
also be rising for pure supply-and-demand reasons. This will be perceived as
inflation by most people, so we're probably facing a perfect storm of
inflation.
As inflation really
takes root in a way everyone can easily see, inflationary expectations will
soar and investors will seek assets that thrive in inflationary times. Of
course this means commodities, primarily gold and silver. At Zeal we've been
deploying in ahead of this trend since the end of the panic. Our trading
results have already been awesome, but we haven't seen anything yet compared
to what will happen to our trades once inflationary expectations start
scaring mainstream investors.
In our latest Zeal Intelligence monthly newsletter at the end of May, our 12 open
stock trades had average unrealized gains of 37%. Our 4 new long-term
investments added in November near the panic lows had average unrealized
gains of 103%. Our 17 open stock trades in our Zeal Speculator weekly alert service had average unrealized gains
of 53% as of the latest issue on June 2nd. All these trades are elite
commodities stocks that will thrive in inflationary times. And thanks to the
Fed, big inflation is coming.
Unfortunately most
mainstream investors are still sitting on the sidelines in cash, too wounded
from the panic to even think about stocks again. But this ostrich approach will prove disastrous. The kinds of inflation this
M0 ramp portends will steamroll cash, rapidly eroding its purchasing power. As
mainstreamers realize this, the capital that will flood into commodities and
their producers' stocks should be breathtaking. Subscribe today to get in the game and ride this unprecedented
event higher with us!
The bottom line is
the panic money-supply growth in the US has been very excessive,
running at multiples of economic growth. And in the case of narrow M0 money,
the doubling in 4 months is literally unprecedented. It scares me. With so
much new money in the system, and the Fed totally unwilling to undo this
terrible inflation over the 6 months since, rapidly rising prices are
inevitable.
We're on the verge
of the first inflation scare of the modern era, a time when epic panic buying
into hard assets and their producers is increasingly likely. Investors who
ignore these dire tidings will probably get crushed by the inflation. But
investors who prudently study the dangers and deploy their capital to thrive
in them will make fortunes. Mark my words, the money-supply data shows big
inflation is coming.
Adam
Hamilton, CPA
Zealllc.com
June 05,
2009
Read
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