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Certain deflationists have recently gone on record saying that
the increase in the Fed's balance sheet is meaingless with regard to creating
inflation because our central bank can't print money, it can only
create bank reserves. The problem with their view is that it both
disregards the definition of money and ignores the process of creating bank
reserves.
Money is commonly defined as "a medium that can be
exchanged for goods and services and is used as a measure of their values on
the market, including among its forms a commodity such as gold, an officially
issued coin or note, or a deposit in a checking account or other readily
liquefiable account." The Fed creates a "readily liquefiable
account" when creating excess bank reserves, so it is also creating
money. Since inflation is properly defined as an increase in the money
supply, the Fed unquestionably creates both money and inflation when it
creates reserves.
The deflationists' error is to suppose that because the amount
of currency has not grown, the money supply hasn't grown. But
the Fed never creates currency - all the printing is handled by Treasury; instead,
it creates bank deposits which are held at the Fed. In ignoring this
"base money," the deflationists make no distinction between having
the Fed's balance sheet at $800 billion or $3 trillion. Doing so is a huge
mistake for both making investment decisions and predicting asset price
levels.
In short, for deflationists to be correct, they must contend
that only money which is currently in circulation can be considered
inflationary, i.e. lead to rising prices. Therefore, they must also believe
that all increases in demand and time deposits should not be included in the
money supply and should not be considered inflationary. This isn't just
wrong, it's grossly wrong.
Not only do the Fed's monetary additions increase the money
supply, but the effect can be vastly multiplied through the fractional
reserve system.
Also, the process of creating bank reserves always first
involves the purchase of an asset by the central bank. The Fed issues
electronic credits to banks in exchange for bank assets, including Treasuries.
Its purchases drive up the demand for those assets, bringing about rising
prices. In fact, Bernanke has clearly stated that the purpose of his
"quantitative easing" program is to raise the rate of inflation,
which in his mind is too low.
What the Fed is accomplishing is a reduction in the purchasing
power of the US dollar. It creates inflation by vastly increasing the money
supply, and thus lowers the confidence of those holding the greenback. If
international confidence in the dollar is shaken, most dollar-based asset
prices will increase - with the exception of US debt.
Deflationists also ignore the rise in prices that is occurring
because of the potential insolvency of the US government. It is not
dissimilar to what happened to Enron shares. Once the accounting scandal
broke, the purchasing power of Enron shares plummeted. It was not because of
an increase in the number of shares outstanding, but because of an epiphany
on the part of investors that the company was totally bankrupt. Logically, shares
representing a stake in a doomed company lost all of their value. Likewise,
aggregate prices will soar if global investors lose confidence in the dollar
due to the realization that the US is incapable of servicing its debt.
Whatever the deflationists may claim about the money supply, the
objective indicators are not looking good for Uncle Sam. The dollar's decline
is abundantly evident when compared to gold, commodity prices, other
currencies, real estate, and the list goes on. The national debt now stands
at over $13.7 trillion, some 94% of GDP. Either due to an insolvent currency
backed by a bankrupt nation or because of the Federal Reserve's endless money
printing, I have no doubt that the deflationists have it completely wrong.
Michael Pento
Senior Market Strategist
Delta Global
Advisors, Inc.
Delta Global
Advisors : 19051 Goldenwest, #106-116 Huntington Beach, CA 92648 Phone:
800-485-1220 Fax: 800-485-1225
A 15-year
industry veteran whose career began as a trader on the floor of the New York
Stock Exchange, Michael Pento recently served as a Vice President of
Investments for GunnAllen Financial. Previously, he managed individual
portfolios as a Vice President for First Montauk Securities, where he
focused on options management and advanced yield-enhancing strategies to
increase portfolio returns. He is also a published economic theorist in
the Austrian school of economic theory.
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