| Inflation: What, Why and How
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Below is an extract from a commentary originally
posted at www.speculative-investor.com
on 13th November 2005.
Monetary expansion
The total US money supply (M3) has expanded
at a 10% annualised rate since mid-May and is up by around
7.5% over the past 12 months. This rapid rate of money-supply
growth is making a mockery of the Fed's monetary tightening,
but there are good reasons to expect that the situation will
change in the near future.
Borrowing associated with residential real estate,
whether it be the establishment of new mortgages or the re-financing
of existing mortgages or the taking out of home equity loans,
has been the biggest influence on the US money-supply growth
rate over the past 10 years. And money-supply growth from
this source has already begun to taper-off and is very likely
to fall further. Evidence that this is the case includes:
a) The rate of growth in home equity loans has
plunged over the past few months and will probably continue
its downward trend due to a general softening of the real
estate market
b) The index of mortgage applications calculated
by the Mortgage Bankers Association recently hit a 9-month
low
c) Trends in mortgage applications move counter
to trends in long-term interest rates. Furthermore, significant
trend changes in long-term interest rates generally lead significant
trend changes in year-over-year money-supply growth rates
by about 3 months. With long-term interest rates having trended
higher over the past two months and having just moved to near
their highest levels of the past year we should see the beginning
of a downward trend in the rate of money-supply growth within
the next few weeks.
Although year-over-year growth rates in the
broadest measures of US money supply (M2 and M3) have moved
higher over the past six months, the bigger picture -- as
shown on the following chart of the year-over-year M2 growth
rate -- is that a downward trend has been in force since the
beginning of 2002.
Our view is that the peak in inflation (money
supply growth) that occurred during the months following the
Sep-2001 terrorist attacks will turn out to be the peak for
this decade. (Ironically, the peak in inflation appears to
have occurred at around the same time as the fear of inflation
was at a multi-decade low). However, we expect gold -- the
ultimate inflation play -- to perform extremely well over
the next several years for two reasons. First, the effects
of the massive inflation of 1997-2002 will be rippling through
the economy and the financial system for many years to come.
Second, even though we are unlikely to see the sort of percentage
gains in the money supply over the next few years that we
saw during the early part of this decade, the greatest beneficiaries
of whatever inflation does occur will be the things that are
in long-term bull markets. And make no mistake; there WILL
be plenty of inflation over the next few years.
Why inflation
When analysts argue for a deflationary outcome
it is generally because they expect prices to fall. However,
price declines that are not CAUSED by a contraction in the
total supply of money and credit are not related to deflation
in any way. For example, the prices of most things made in
China will probably continue to slide almost regardless of
how much inflation (money supply growth) there is in the world.
The primary reason why there will be more inflation
over the next several years is that genuine deflation -- a
contraction in the supply of money and credit -- is not an
option. It's not, for instance, feasible for there to be a
1-2 year period of deflation that washes away the current
excesses and paves the way for the next expansion. This, in
turn, relates to the way new money is borrowed into existence
under today's monetary system. The problem, in a nutshell,
is that when new money is created by the expansion of debt
the amount of repayment obligations will always be much higher
than the total supply of money (because each new dollar brings
with it a liability in excess of one dollar due to the obligation
to pay interest). Therefore, once the total amount of debt
reaches a high level the inflation either continues or the
system collapses. And in our opinion, we are a very long way
from the point where the inevitable collapse occurs.
A secondary reason to anticipate a continuation
of the inflation is that current liabilities are denominated
in nominal dollars, not inflation-adjusted dollars. For example,
the US Government has trillions of dollars of future social
security obligations and US corporations have trillions of
dollars of pension-related obligations, but no one is promising
that these obligations will be met in real terms. Regardless
of whether the dollar holds its purchasing power or loses
90% of its purchasing power over the coming 10 years, the
number of dollars that will have to be paid to satisfy these
obligations will remain the same. With this in mind, what
are the chances that the Fed and the Government will do anything
other than follow policies that erode the purchasing power
of the dollar?
How inflation
Ben Bernanke's November-2002 speech titled "Deflation:
Making Sure It Doesn't Happen Here" caused a lot of controversy,
but from our perspective the man who will be taking over from
Alan Greenspan in January of 2006 was just stating the obvious.
It is ridiculous to assert -- as some analysts regularly do
-- that an institution with the power to create an unlimited
amount of dollars would be powerless to continue the inflation;
and that's regardless of whether inflation is correctly defined
as an increase in the supply of money or incorrectly defined
as an increase in the general price level. The aforementioned
speech simply described some of the arrows in the Fed's quiver
(refer to the part of the speech with the sub-heading "Curing
Deflation" for details).
Over the coming year or two we doubt that the
Fed will have to take any of the special measures outlined
by Ben Bernanke. The amount of money-supply growth generated
by the mortgage financing/re-financing industry looks set
to decline over the coming one or two quarters, but we suspect
that the US Government will take up a lot of the money/debt-creation
slack. In particular, the massive increase in government spending
associated with the re-building of New Orleans should add
a few hundred billion to the money supply over the coming
2 years; and then there's the on-going spending associated
with Iraq, the potential for more large-scale war-related
spending/borrowing if Iran pushes forward with its nuclear
program, the $300B of future government spending on roads
and other surface transportation authorised by President Bush
in August, spending/borrowing associated with preventing or
combating a 'bird flu' pandemic, etc.
The bottom line is that the central bank
and/or the government are quite capable of keeping the inflation
going for many more years; and, as discussed above, they effectively
have no choice other than to continue the inflation. What
they can't do is control the effects of inflation, that is,
they can't control which investments and which sectors of
the economy will be the main beneficiaries of the inflation
they create.
*****
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