The raging debate between the deflationists and the inflationists has yet to be resolved. Is it possible that it might be resolved sooner than we think?
The deflationists have pointed out that a massive global economic downturn and investment deleveraging has caused us to enter a deflationary phase of the economy, causing the prices of most assets to decline. Some of this camp argue that it could last years, recreating something like Japan's "Lost Decade".
But the government is desperately trying to "reflate" the economy by guaranteeing banks, lowering rates, creating stimulus, and driving down interest rates. Inflationists say that these pure monetary actions by the government are likely to stoke inflation – possibly hyperinflation.
So far, it's done little, but these things always have a lag. Credit as measured by a number of indicators has loosened up a bit.
The key to monitoring what happens with the monetary stimulus and potential future inflation are the money supply statistics. John Williams, the economist who runs the brilliant site www.shadowstats.com, has been monitoring the "M3" or broad money supply, and he says there are some recent signs that it is accelerating. From his website:
"M3 Growth Surges. .. For December, annual M3 growth surged to roughly 10.7% from its recent trough of 9.1% in November."
Source: www. shadowstats.com
This would be an interesting development, because through December of 2008, measures of M3 had been shrinking -- reflecting the deflationary nature of the credit contraction. Williams' thesis is that it appears that this credit contraction may be waning, and that a turn in M3 will unleash the huge explosion in "M1" money supply, fueling a surge in inflation. I've posted more thoughts on this over at Futures Fanatic (www.futuresfanatic.com).
As you can see by the charts below -- M3 and M1 have been "fighting each other" -- headed in different directions. The decline in M3 has overwhelmed the surge in M1, causing deflation. But if M3 now turns up, what you have is an overwhelming surge in both measures pushing toward the inflation direction.
US Broad Money Supply (M3)
Source: St. Louis Fed M1 measure
We should watch the markets carefully over the next couple of months to see if these monetary effects start being reflected by markets. The signs would be: Rising gold prices (GLD), a weakening of treasury bonds (TLT), and a rally in stocks (SPY), with a return to more risky assets including emerging asset markets (EWM, FXI).
I posted a "Reflation Portfolio" here a couple of weeks ago in case you wanted to be positioned for a coming rebound in inflationary markets.(http://seekingalpha.com/article/113655-the-reflation-top-ten-portfolio). I have established some early positions and I would like to increase them. However, I would like some of the data -- and the market's reaction to the data -- to confirm some of these theories before I act on them further.
