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History has shown us time and again
that out of control money supply expansion creates inflation. In light of
the trillions of synthetic dollars that have been injected into the
economy by the Federal Reserve over the past five years, most observers
(this one included) had expected prices to spiral upward. But in making
these determinations, many of us forgot to factor in the supply side of
the supply/demand equation. Inflation remains low now because of game
changing events that have reduced the demand for money.
As far as the Federal Reserve and
the President's Council of Economic Advisors are concerned, inflation is
currently holding at around 1.4 percent. However, these authorities
choose to focus only on the most generous measurement tools, like the
core PCE index. Other common indices, such as the CPI burn much hotter.
Current CPI is at 2.9 percent, the highest year-over-year increase since
2008 and more than twice the rate of the core PCE. However, it is widely
recognized that even these figures have been manipulated downwards to
benefit the Government.
Many more skeptical observers
suspect that the real rate of inflation is far north of 6 percent,
perhaps closer to 10 percent. But even this figure is far below the rate
of expansion that our money supply has undergone over recent years. As of
November 17, 2011 the Federal Reserve reported that the U.S. dollar
monetary base has increased by 28 percent in just 2 years. Logically we
should expect to see a direct correlation between the money supply and
the rate of inflation. What explains the breakdown of this relationship?
The dramatic collapse
in the real estate market, and the resulting recession and deleveraging,
have created a very different dynamic among many consumers,
businesses and banks. The fragile economy and lagging global
uncertainties have inspired dramatic removal of risk, thereby slowing the
circulation of money. The dimming of animal spirits should act as a
weight on the general price structure. Put simply, a recession should
push prices down.
The savings, retirement accounts,
and real assets of consumers suffered massively in the recession of
2008/9. Cash flow shortages drove many companies into liquidation. Banks
that had speculated in real estate or had made irresponsible so-called
covenant-light loans had to be rescued by the taxpayer or by other more
conservative banks. Therefore, corporations and banks joined consumers in
becoming far more conservative. Indeed, although banks are stuffed full
of deposits, bank finance remains extremely tight.
Before the crash, many consumers and
corporations had grown accustomed to the continual growth of asset
prices. Therefore they grew comfortable with leverage as a means to
safely increase wealth. Even banks shared this sanguine view.
Today, consumers have become
conservative, spending mostly on what they see as essentials.
Corporations have adjusted, cut costs dramatically and have accumulated
an aggregate of some $2 trillion in cash. The Fed now pays banks interest
on excess reserve deposits and charges near zero percent for loans. In
response, banks prefer to lend to the Fed or government, via Treasury
bonds, than to lend to ordinary customers, which, under new regulations,
requires more capital reserves. Who can blame them?
When the Fed injects money into its
distribution system of banks, the money becomes part of the monetary
base. It is only when these banks lend the money that it becomes part of
the money supply. If the demand for money is muted, inflation will remain
muted no matter how much money is made available as monetary base.
Indeed, this is the reason that the stimulus packages have enjoyed so
little success in terms of increasing consumer demand and jobs.
Therefore, in the absence of demand
from consumers and corporations, massive monetary injections of synthetic
Fed money have little effect on inflation. The key question remains as to
how long the dramatic change in consumer attitude will last and keep
inflation subdued?
The price of gold is revealing on
this point. A very different dynamic exists in the market for gold than
does in the market for electronics, furniture or stocks. Gold buyers by
nature are extremely sensitive to monetary policy, and tend to look to
gold when central bankers lose credibility. The gold market is also
wholly international and is driven more by the growth in the emerging
markets rather than the stagnation in the developed world. As a result,
the dollar price of gold has been much more correlated over the long term
with the increase in U.S. money supply.
So beware of the recovery. Any
wakening of animal spirits in the U.S. will likely stir the dormant threat
of inflation, which if it were to reveal itself in force, may very well
short-circuit the recovery itself. This is a riddle that may be
impossible for Mr. Bernanke to decipher.
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