Why High Inflation Will Not Take Hold

Long before the Federal Reserve Board’s March 19^th announcement of its intention to engage in quantitative easing, a debate has raged over whether the U.S. economy will experience inflation in the not too distant future. One of the main pro-inflation arguments is that given the enormity of the U.S. debt and the likely inability of the U.S. to achieve sufficient economic growth to service that debt, the only feasible “way out” for the government is to print money, thereby devaluing its currency and making its fixed debt less onerous in real terms.

Consequently, when the Federal Reserve announced a few weeks ago its intentions to print money to buy Treasury bonds, it was hardly surprising that a new round of inflation warnings and condemnations of the government was unleashed. Implicit in these admonitions is the notion that the U.S. will experience not just inflation but high inflation (and potentially even hyperinflation)—otherwise there would be no need to raise a hue and cry.

But is the case for high inflation as much of a slam-dunk as many of its proponents believe? Does the printing of money guarantee that the U.S. will be destined for significant, if not hyper-, inflation in the not too distant future?

In short, no. While the chain of logic from printing money to inflation sounds reasonable, the printing of money does not guarantee high inflation per se. Indeed, we actually have a recent empirical example of a government that radically expanded its money supply and engaged in quantitative easing with little to show for it by way of inflation—namely, Japan, over the last two decades.

To see why an expansion of the money supply may not result in inflation, recall the Quantity Theory of Money, which states that:

M x V = P x T

In the preceding equation M is the money supply, V is the velocity of money, P is the level of prices, and T is the number of transactions in the economy. Economists usually labor under the assumption that V and T are relatively fixed. Therefore, if the money supply (M) increases, the level of prices (P) must increase as well. However, as we are now finding out in painful fashion, the velocity of money is far from fixed, and has essentially plummeted. Thus, even with an increase in the money supply, inflation (let alone hyperinflation) is not necessarily inevitable—the velocity of money must be taken into consideration as well.

While inflation may not be inevitable, one cannot simply dismiss it as an improbability either. For the U.S. to escape the menace of high inflation, then—given the increase in its money supply and assuming a fixed or lower number of economic transactions—the velocity of money must reset and stabilize at a lower level (such that at most only mild, desirable, inflation arises). Indeed, the pro-inflation argument takes it as a given that the velocity of money will inevitably pick up during any economic recovery, thus leading to significant amounts of inflation.

This raises the question: Why might the velocity of money reset and stabilize at a lower level? To this question, we would like to put forward two reasons that the velocity of money may diminish and remain diminished in the years ahead. One reason is cyclical, the other psychological, and both are mutually reinforcing.

The Cyclical Case Against High Inflation

In late 1999, at the height of the dot.com bubble, Michael Alexander wrote a rather prescient, if obscure, book called Stock Cycles: Why Stocks Won’t Beat Money Markets Over the Next Twenty Years. Alexander, a Ph.D. research engineer, looked at 200 years of history for the S&P 500 and its precursors and found that—like clockwork—market cycles alternated between secular bull and secular bear markets roughly every thirteen to seventeen years.

In the course of his analysis, Alexander also made the fascinating discovery that the drivers of secular bear markets alternated between two distinct causes: high inflation and low real earnings growth.

To gain an appreciation of this cyclicality, consider the following chronological list of (completed) secular bear markets in the U.S. and their causes:

• The secular bear market from 1802-1815 was caused by high inflation
• The secular bear market from 1835-1843 was caused by low real earnings growth
• The secular bear market from 1853-1861 was caused by high inflation
• The secular bear market from 1881-1896 was caused by low real earnings growth
• The secular bear market from 1906-1921 was caused by high inflation
• The secular bear market from 1929-1949 was caused by low real earnings growth
• The secular bear market from 1966-1982 was caused by high inflation

Notice a pattern? On this basis, and using a unique valuation metric (called the price-to-resources ratio) that showed the S&P 500 to be extremely overvalued as of late 1999, Alexander predicted that at some point in the year 2000, the U.S. would enter into a secular bear market driven by low real earnings growth—a secular bear market that could possibly last until the year 2020 (hence the subtitle, Why Stocks Won’t Beat Money Markets Over the Next Twenty Years).

In hindsight, this forecast could not have been more accurate. Few would argue with the claim that the S&P 500 has been in a secular bear market since early 2000—real returns over this period have been negative every step of the way, even when the S&P 500 was reaching new highs in October 2007. Indeed, the dot.com bubble deflated mainly because investors’ collective mania ended and they realized that companies did not have the requisite earnings to support the market’s lofty valuations. In a similar fashion, the most recent peak-to-trough plunge in the index has been accompanied by a commensurate collapse in corporate earnings. As the historical cycles would suggest, high inflation has not been a problem during this secular bear market. Thus, one can say with a fair bit of confidence that our current secular bear market cycle has indeed been driven by low real earnings growth.

Consequently, if the current secular bear cycle remains consistent with historical cycles dating back to the late 1800s—and so far this cycle has preternaturally stuck to the script—it is possible that we have anywhere from four to eleven more years of the current cycle to look forward to—where high inflation is not likely to be a problem.

Now, we fully admit that the cyclical case against high inflation is a bit unsatisfying, as it does not rely on any impressive chain of logic (nor does it deal directly with the velocity of money). Instead it simply posits that the future will be like the past. Despite the simplicity of the argument, however, there may be legitimate reasons to suspect that real earnings growth in the U.S. will remain low for a prolonged period of time. These reasons are related to the type of recovery the U.S. economy will likely experience, along with the resulting effects the economic downturn and its wealth destruction will have on consumers’ psyches—both of these factors are mutually reinforcing and actually do impinge on the velocity of money.

The Case for Continued Low Real Earnings Growth

Over the long-term, corporate earnings grow at roughly the same rate as nominal GDP. However, from 2003-2007 there were more than a dozen consecutive quarters where U.S. corporate earnings grew at a double digit rate (year-over-year), greatly outstripping nominal GDP growth over the same period. Given this historic run of earnings growth above the long-term growth rate of nominal GDP, we may see a similar extended run where earnings growth underperforms nominal GDP (as a matter of fact, we are several quarters into such a run).

Moreover, if, as some prognosticators are suggesting, we have an L-shaped “recovery” or, as Microsoft (MSFT) CEO Steve Ballmer calls it, a “resetting” of the economy— during which the economy stabilizes at a lower level and then grows below potential for several years (accompanied by persistently high unemployment)—an extended run of low real earnings growth for U.S. corporations becomes even more plausible.

Further, when one considers that corporate earnings growth during the middle part of this decade was inflated by significant amounts of both corporate and consumer leverage—leverage that is being drained from the system and most likely not coming back any time soon—the case for a prolonged earnings slump becomes even stronger. As a result, the current secular bear cycle is likely to continue to be driven by low real earnings growth.

While a low-real-earnings-growth environment does not necessarily preclude the possibility of high inflation, a case can be made that such an environment will have a particular lasting effect on consumers’ psyches (with a resultant dampening effect on the velocity of money and, therefore, on inflation), which in turn will feedback into the real economy, thus helping to prolong the earnings slump. Lather, rinse, repeat.

The Psychological Case Against High Inflation

As the economy has begun the process of resetting to a markedly lower level, corporate earnings have plummeted, leading to a dramatic rise in unemployment. Those who still have jobs are unlikely to have psychological comfort, however, as they are potentially on a knife’s edge between losing their job in the near future or having a salary that stagnates or declines on account of the absence of corporate or small-business earnings. Alongside this unemployment or stagnation of wages, the net wealth of many consumers has been halved on account of losses in their 401(k)s and in the values of their homes. What’s more, prior to the crash in their net wealth, many consumers had negative or zero savings rates, with substantial levels of debt relative to their pre-crash net worth.

Thus, the average consumer:

a) Is either unemployed, in danger of becoming unemployed, or quite likely to be earning a stagnant or declining salary in the near future

b) Has lost a significant amount of retirement savings and home value

c) Has a non-trivial amount of debt relative to net worth

d) Has not been saving enough to provide a buffer to weather a prolonged economic downturn

It follows from the above, then, that the average consumer is in very real danger of having to take a step down in living standards. Taking a step down in living standards is not easy psychologically, but will almost certainly be necessary for a large portion of U.S. consumers.

In light of the angst that consumers will be experiencing on account of their precarious economic condition, one way to mitigate that angst (short of getting a new high-paying job or winning the lottery) is by saving as much as possible. Saving allows consumers to feel as though they are constructively working to better their situation, which will marginally lessen their despair (and thus will be embraced tenaciously as one of the only means of providing a modest bit of psychological comfort).

The psychological benefit of saving stems from its practical benefits— namely, it helps to rebuild wealth lost in the stock and housing markets and to provide a cash buffer for the consumer to ride out a potentially prolonged economic downturn. Indeed, the savings rate in the U.S. has gone from 0% to 5% in the past year alone, indicating that the conjecture that consumers will begin to save tenaciously is more than just idle speculation.

What are the consequences, then, of a higher rate of consumer savings? First and foremost, discretionary spending on non-necessities will plummet (and has plummeted), which will serve to prolong the earnings slump for corporate America—in turn, a prolonged earnings slump will likely keep unemployment higher for longer and wages stagnant for longer, thus reinforcing the consumer’s desire to save.

Dovetailing with the consumer's newfound desire to save is the tightening of credit standards and the economy-wide deleveraging. Both of these factors suggest that consumers won't be adding new layers of debt at the same rates we have seen in the past. Indeed, the psychological desire to save coupled with consumers' diminishing inability to service existing debt with their now stagnant or non-existent incomes might cause them to shun debt for the foreseeable future.

This deleveraging coupled with the increased savings rate will likely reinforce the diminution of demand for non-essential goods and services, which in turn will likely constrain the velocity of money (at much lower levels), and thus, constrain inflation—despite the large growth in the money supply.

Thus, to summarize:

• An increase in the money supply is insufficient to produce inflation—the velocity of money must be taken into consideration as well (see the experience of Japan over the last two decades).
• The U.S. has been in a secular bear market for stocks since 2000. This secular bear cycle has been driven by low real earnings growth and not by high inflation.
• The recent dislocation in the economy will likely lead to a “resetting” of the economy at a lower level of economic activity. This lower level of economic activity will likely keep unemployment higher for longer and will depress wage growth (as a prolonged earnings slump will not support higher labor compensation).
• Consumers, with their stagnating or non-existent income, high levels of debt, and having lost a significant portion of their net wealth through the collapse of the stock and housing markets, will begin saving at much higher rates than we’ve seen in the recent past (this is already taking place). This increased savings will in part be driven by the consumers’ psychological desire to feel as though they are constructively acting to mitigate their precarious economic conditions.
• Higher rates of consumer savings coupled with economy-wide deleveraging will lead to lower demand for non-essential goods and services.
• This lower demand for non-essential goods and services will serve to reduce the velocity of money to lower-than-normal levels and, therefore, keep inflation in check.

To be clear, we are not suggesting that deflation will necessarily take hold. Rather, we are suggesting that high inflation is unlikely to result (for the reasons presented above)—despite the growth in the money supply. In a subsequent article, we hope to discuss the repercussions of a low-to-moderate inflation environment on various financial markets (in the context of a low-real-earnings-growth secular bear cycle).

Disclosure: Author is long SDS. Positions are short-term and likely to change intraday.

Comments

[User 143167:]

You neglected three important points:
1, IT development makes people in modern society obtain information much much faster they did in the past. So inflation expectation could actually move back and be priced in much quicker too. This increases the volatility of almost every asset prices, so it will pass onto CPI, PPI much quicker too.
2, Commodities nowadays become a popular choice of asset that most of the retail investors could access to. That was not the case in the past.
3, D&S is much less impacted by the US economy going forward due to globalization and the rise of EM economies.

Apr 24 04:45 AM

[morph366:]

A very good article but I agree with the point above that your perspective is too US-centric. The prognosis for the US consumer may well follow your reasoning but increasingly there are the G20 economies to consider and many of them do not have the structural problems to contend with.

Another problem is that the demand for credit by governments in the capital markets will be so massive that the cost of capital might increase a lot more than current forecasts are based upon (esp in the US and UK) and this will have inflationary implications.

Apr 24 04:56 AM

[Raymond Mic...:]

Thank you. In regards to your last point--and I'm thinking out loud here and making no pretense about knowing the answer--if the cost of capital increases because governments need to borrow a massive amount of money, might that not continue to harm corporate earnings (as the cost of capital for corporations will also increase, meaning their net financial expense will increase and their earnings will suffer) and at the same time induce more consumers to save because now interest rates would be higher--thus reinforcing the dynamics suggested in the article? I could be missing something for sure, but that seems to be a not too implausible outcome, no?


On Apr 24 04:56 AM morph366 wrote:

> A very good article but I agree with the point above that your perspective
> is too US-centric. The prognosis for the US consumer may well follow
> your reasoning but increasingly there are the G20 economies to consider
> and many of them do not have the structural problems to contend with.
>
>
> Another problem is that the demand for credit by governments in the
> capital markets will be so massive that the cost of capital might
> increase a lot more than current forecasts are based upon (esp in
> the US and UK) and this will have inflationary implications.

Apr 24 05:07 AM

[capitalisth...:]

Nice try but your analysis fails on 2 obvious points.

1. You cannot draw comparisons to Japan. Japan had and has a huge personal savings reserve. Japan didn't have to print money b/c they just tapped their savings; unlike the US which already has a huge government and private debt.

2. Using your equation M x V = P x T the only way to keep prices(P) from rising when the money supply (M) is rising is for the number of transactions (T) to decrease. But if the number of transactions decreases than by definition is the economy is shrinking. If the economy is shrinking than the government's tax receipts are decreased which means the government has to print more money (increase M). So to avoid inflation the number of transactions will have to decrease more which means continued shrinking of the economy which meas the government will have to print more money and so on and so on.

The only way to avoid inflation when you print money is to have an ever shrinking economy or productivity gains which can sop up the extra cash.

Sorry guys, there's no easy fix. Divest yourself of dollars and buy commodities.

Apr 24 06:21 AM

[Raymond Mic...:]

What if V decreases and stays low? As it has and may remain....


On Apr 24 06:21 AM capitalisthero.com wrote:

> Nice try but your analysis fails on 2 obvious points.
>
> 1. You cannot draw comparisons to Japan. Japan had and has a huge
> personal savings reserve. Japan didn't have to print money b/c they
> just tapped their savings; unlike the US which already has a huge
> government and private debt.
>
> 2. Using your equation M x V = P x T the only way to keep prices(seekingalpha.com/symbol/p)
> from rising when the money supply (seekingalpha.com/symbol/m)
> is rising is for the number of transactions (seekingalpha.com/symbol/t)
> to decrease. But if the number of transactions decreases than by
> definition is the economy is shrinking. If the economy is shrinking
> than the government's tax receipts are decreased which means the
> government has to print more money (increase M). So to avoid inflation
> the number of transactions will have to decrease more which means
> continued shrinking of the economy which meas the government will
> have to print more money and so on and so on.
>
> The only way to avoid inflation when you print money is to have an
> ever shrinking economy or productivity gains which can sop up the
> extra cash.
>
> Sorry guys, there's no easy fix. Divest yourself of dollars and
> buy commodities.

Apr 24 06:29 AM

[Raymond Mic...:]

Incidentally, when stocks are in secular bear markets, commodities are in secular bull markets. So commodities are likely to do ok, but if they do too well, that puts the brakes on the economic recovery, which hurts demand, which hurts commodities prices. Thus, we are likely to get a modest amount of inflation, but too much would just work against the economic recovery. Moreover, the government would have to withdraw that liquidity at some point, thus increasing interest rates and likely damaging a still-languishing economy, which would kill any excessive inflation on the spot.

Moreover, given the common knowledge that the Fed is printing money, why is gold just hanging out? And TIPS as well? Super high inflation is not nearly a given.


On Apr 24 06:21 AM capitalisthero.com wrote:

> Nice try but your analysis fails on 2 obvious points.
>
> 1. You cannot draw comparisons to Japan. Japan had and has a huge
> personal savings reserve. Japan didn't have to print money b/c they
> just tapped their savings; unlike the US which already has a huge
> government and private debt.
>
> 2. Using your equation M x V = P x T the only way to keep prices(seekingalpha.com/symbol/p)
> from rising when the money supply (seekingalpha.com/symbol/m)
> is rising is for the number of transactions (seekingalpha.com/symbol/t)
> to decrease. But if the number of transactions decreases than by
> definition is the economy is shrinking. If the economy is shrinking
> than the government's tax receipts are decreased which means the
> government has to print more money (increase M). So to avoid inflation
> the number of transactions will have to decrease more which means
> continued shrinking of the economy which meas the government will
> have to print more money and so on and so on.
>
> The only way to avoid inflation when you print money is to have an
> ever shrinking economy or productivity gains which can sop up the
> extra cash.
>
> Sorry guys, there's no easy fix. Divest yourself of dollars and
> buy commodities.

Apr 24 06:33 AM

[CautiousInv...:]

I like your article and many of the comments.

The Fed has expanded its balance sheet to $2.3 trillion..........and I think it was around $.8 trillion at the end of 2008. And it is likely to grow to over $3 trillion.

This is not say that money supply has expanded at the same rate as the Feds balance sheet is a reflection of the monetary base......not money supply. Much to the frustration of the Fed and administration, many excess reserves are not being loaned out. It is the latter activity that expands money supply..........as conventionally measured.

Should lending gain traction, which I doubt to be case, then discussion of money supply will be most relevant as will how to tame the possible inflation. At that point, the Fed must reduce reserves and the size of its balance sheet.

Feldstein and others worry, though, the Fed will not be able to unwind its balance sheet in the manner in which it states. And this has to do with its less than liquid holdings in agency debt and the assets being acquired under TALF.

Apr 24 07:10 AM

[casinospt:]

"Using your equation M x V = P x T the only way to keep prices(P) from rising when the money supply (M) is rising is for the number of transactions (T) to decrease. "

capitalisthero.com, I'm sure you wanted to say "for the number of transactions (T) to increase. "

A decrease in T would be inflationary.

The big question is the future beaviour of V, and Raymond adresses the issue. But I don't think Raymond is right: "velocity of money will reset and stabilize at a lower level". I think it will revert to the mean sooner (2010?) or later (2012?).

Apr 24 07:19 AM

[DONE_SONZ:]

Inflation and or default.Either way, gold is the way to go.

Apr 24 07:54 AM

[LaughingTrader:]

I am confused (not unusual in these troubled times). In your article you stated:

"However, from 2003-2007 there were more than a dozen consecutive quarters where U.S. corporate earnings grew at a double digit rate (year-over-year), greatly outstripping nominal GDP growth over the same period."

and then in your conclusions you summarized:

"The U.S. has been in a secular bear market for stocks since 2000. This secular bear cycle has been driven by low real earnings growth and not by high inflation."

These seem to me to be conflicting statements.

Apr 24 08:08 AM

[tim leary:]

I see no one has bothered to actually look at how much money the government is creating. I have. 100 billion a month out of thin air. If this keeps up, the money supply will have doubled from 9/08 to 12-09. Could you point to me anywhere in our financial history that we have doubled the money supply in 18 months? Assuming of course that we continue for the rest of the year, that is exactly what is going to happen.

Now, why are people saving? You are correct that indeed they have. This savings is driven by fear of the future and not done because Americans have suddenly become frugal. What will they do as prices fall which they have and are for the near term anyway?
Will they buy things that are attractively within their grasp or will they continue to save? I dont have that answer, but it will be a factor.

And how much more will the government need to print, if defaults in commercial real estate hit these same troubled financial institutions?

Finally, what if China and others decide we are printing too much money and become concerned and the money we print is no longer acceptable for repayment at what they fear might be a weakened dollar? We will still print the money and continue to try and spend our way out.

Back in the old days of economics, if you double your money supply, you cut the value of your currency by 50%.

There are way to many variables to predict when inflation will begin....but when you print it, it will come. My best guess? 1 year after the headlines are shouting about commercial real estate defaults and we enter the middle innings of this ballgame. The last out of the 9th wont happen until inflation starts, which by then, will be a welcome relief to the real estate markets which began this whole thing. Unfortunately, we will have to take all the bad that comes with it.

Apr 24 08:09 AM

[Mono:]

Good read Raymond-

Unfortunately I am not as optimistic as you as history, and you did a fine job sifting through it, will repeat itself. Unfortunately we will push the green button on the printing press for some time now and replace the ink cartridge. It is a global race to zero interest rates and you can not simply turn that around. It will take time and subsequently there will be more QE. Serbia crica 1993- 500 billion dinar note...Im not saying we are coming to the 1000$ bill but price controls wouldn't completely surprise. With the shenanigans that have been happening, it truly wouldn't surprise me. Government debt issuance will not find any buyers unless it is at a deep discount, and this will continue for some time until confidence in the system returns. Again- all the while we will be bailing out the incompetent by taking money from the competent.

When you squeeze out the toothpaste from the tube...you can't just put it back in. The market is flooded with USD

Apr 24 08:16 AM

[felixd:]

You discuss behaviour of consumers and private investors but somehow miss the single biggest force in the economy....government. Government spending is on its way to 30% of GDP, which is probably artificially low given the fact that new government regulations (tax onC02 for example) will certainly choke future growth. History shows that huge growth in money supply and simultaneous growth in government as % of GDP does indeed lead to hyperinflation. We could escape the trap by cutting gov spending and limit regulatory regime to spark entrepeneurial growth but, at least right now...we are moving in the opposite direction. Pipers eventually have to be paid.

Apr 24 08:59 AM

[K T Cat:]

You're missing a crucial point - the need to print goes off into the future as far as the eye can see. The current administration will be running trillion dollar deficits for a decade with no one out there to buy the debt save China and China doesn't want to do it any more. I did some back of the envelope calculations here

ktcatspost.blogspot.co...

and discovered that there isn't enough money in the world to fund our deficits. While you're right in the short run, you're wrong in the long run. In the end, a country that endlessly prints money to cover its debts is going to kill its currency.

Apr 24 09:30 AM

[wg:]

this analysis is perfect gobbldygook. If you inject double or triple the amount of currency into circulation, as the Obama government intends to do, you WILL get inflation. Whether it is "hyper" or not, remains to be seen. But it WILL likely be "double digit."

Apr 24 09:31 AM

[doomaise:]

While I agree that the US is not at any risk of of hyper (or high) inflation, it's not really because of any of the lovely theoretical analysis you've done above. Taking a more common sense approach, Money supply is NOT increasing. That is if you correctly define Money Supply as Money + Credit.

The economy was inflated based on a massive amount of credit that was unsustainable, and not repayable. This bubble has popped and people are defaulting on their credit. Imaginary "fake" money (credit) is disappearing, while the Federal reserve is printing a bunch of paper money. But the fact is that the imaginary fake money is disappearing faster than the Fed is printing paper money. This is the reason why we're not at risk of inflation....because, in fact, we are in a period of deflation.

Apr 24 09:52 AM

[peterthepai...:]

I like this article a lot...

it makes sense to me...

below is an url worth visiting and some exerpts from it...

..."Please consider this audio with Austrian Economist Frank Shostak on Mises on September 30, 2008 discussing recent actions by the Fed....

"Will this printing create [price] inflation? This is dependent very much on what money will do next. If banks will not lend and banks sit on that cash forever and ever like the great depression because the risk is too high and the banks do not know if the lending will end up in good assets or bad assets, and because banks are in so many bad assets now they probably will not lend at all.

That is the observation that Murray Rothbard made, that during the Great Depression that banks have chosen not to lend because the risk of accumulating bad assets was far to high. So they were sitting on massive reserves. That is what is developing right now.

A good example is what happened in Japan in 2001-2002 where the Bank of Japan pumped 300% at one stage and lending continued to collapse. I expect similar things to happen here. If lending will not increase we can conclude this will not be inflationary.
I agree whole heartedly with Shostak and suggest we are following the Japanese model. This has been my thesis for years....

...Political Will vs. Consumer Psychology

What happens next depends somewhat on the political will of the central banks and politicians. However, it depends more on the psychology of the borrowers. If consumers and businesses refuse to spend and instead pay back debts (or default on them along with rising unemployment), the picture simply is not inflationary, at least to any significant decree.

The credit bubble that just popped exceeded that preceding the great depression, not just in the US but worldwide. Thus, it is unrealistic to expect the deflationary bust to be anything other than the biggest bust in history. Those looking for hyperinflation or even strong inflation in light of the above, are simply looking at the wrong model.

At some point the market value of credit will start expanding again, but that is likely further down the road, and weaker in scope than most think." mish

globaleconomicanalysis...

i have yet to find anyone who makes more sense to me on this bust...petey

Apr 24 10:04 AM

[TarCottage:]

Comments I have read so far are quite interesting.

I agree we are in a secular bear market for stocks and a secular bull market for commodities that started in 2000.

Regarding the statement that from 2000 on, growth in real corporate earnings has been low, is probably correct if you factor in the large devaluation of the U.S. dollar during this period.

However I disagree with the author that since 2000 inflation has not been a concern. I estimate, based upon the increase in the price of gold expressed in U.S. dollars, that real inflation has been near double digits since 2000.

The real problem we all face in trying to figure out the true rate of inflation in a fiat money world is that, except for maybe gold, we have no reliable fixed horizon on which to benchmark inflation against.

The annolgy I use is this. Imagine Uncle Sam, Mr. Yen, Mr. Euro, Mr, Pound, Mr. Ruble, etc. all falling in space. Without a fixed horizon to reference to, if Uncle Sam is falling faster than Mr. Yen and company, then at least two observations could be made. One, Uncle Sam is falling faster than Mr. Yen and company. Or two, if uncle Sam isn't falling, then Mr. Yen and comapany must be going up. Your answer probably has a lot to do with how you preceive things.

My view is that all the currencies are constantly being inflated, some faster than others. I use gold as my fixed horizon.

Best Regards to All

Apr 24 11:21 AM

[Suncatcher:]

I think the rate of inflation is whatever the government tells us it is. Don't like the numbers- adjust the "basket". If anyone wants to live in Japan over the last 20 years raise your hand. I thought not. Japan right now, for all they have been attempting, is worse off then we are right now. Let's face it; we are headed, in America, more than ever before, to where our politicians decide who the winners and losers are. The rulers throughout history are always sure that their peers and their own economic interests are protected but they are content with removing more of the harvest from those not smart enough to rule. I think we are facing diminished lifestyles in this country the cause will have many authors, what can't be analyzed is if the majority will get angry enough to take it to the streets. Looks like things are heating up in other places. Can the money and social managers work their pointy-headed magic to keep the road from getting too bumpy. We'll see.

Apr 24 11:22 AM

[notsosmart:]

cant have inflation @ a app.15% unemployment.whos going to raise their price? auto?house? clothing? insurance(values going down).even food cant go up although shrinkage of weights & measures will continue.people have more stuff than they need.how long can you go without buying stuff?

Apr 24 11:24 AM

[LCACM:]

A lot of these economic ideas probably need to be updated to take into account the vastly increased number of people today compared to the 1930's. In 1930 India's population was closer to 250 Million, and probably a similar number for China. Now India and China together have over 2.2 billion people, almost 5 fold increase. Other parts of Asia, probably have experienced a similar increase in population. Interestingly none of the analysis that I have seen so far seems to take this fact into consideration. These simplistic financial equations may have had validity in a world prior to Assembly Lines, Instant money transfers, jet travel and low population density. Current economic models need to take into account the current population as well as all the new technological advances that have taken place, to think of a realistic solution that makes sense in April 2009 and not 1802

Apr 24 11:37 AM

[Insiderman:]

Maybe I missed this in the comments but if V becomes affected by sentiment (and it has), then a rapid increase in V will have to be accompanied by a rapid decrease in M. Unfortunately, rapidly decreasing M requires that the Fed rapidly sell Treasury securities. increasing the reserve requirement (an elephant gun), etc.

How will the Fed sell Treasuries into this market without a HUGE decrease in Treasury prices and consequent increase in interest rates... usually at a lag. So we'll likely have a brief period of inflatiion accompanied by--yet again--a recession.

As a technical addition to the author's formula, if you use T as transactions, then you cannot use Pi as price level. MV = Sum (Pi x Ti) where Pi is the price of the ith transaction Ti. The MV = PQ formulation, where Q is the real value of final expenditures. I prefer the MV = PY formulation because Y can be used to indicate real income or yeal expenditures in the basic GDP model.

So, if V increases dramatically, M must fall dramatically. Typically P and Q will also shift about in the short-term. Unfortunately, government operational, administrative, and recognition lags will tend to cause the adjustment of M to be inaccruate with respect to the impact of V. P and Q fluctuate cyclically in the process.

Apr 24 11:39 AM

[p church:]

What an interesting debate. The bottom line is we are trying to figure out what to invest in. Since gold pays no dividends, there isn't much buffer against being wrong about deflation so risk/reward there doesn't appear attractive. The sound arguments above would make it unclear which way inflation is headed. Oil, on the other hand, appears much more clear cut. A declining world supply and a temporary softening of demand - soon to likely resume to increasingly rising = a return to $75 or $80 a barrel. Over $100 seems very likely within a year or two. Regarding savings, the elimination of the home equity cash machines can be attributed, not the sudden prudence of America. Lasting deflation appears unlikely. Buy Oil, not Gold.

Apr 24 12:01 PM

[Zee4Money:]

I think you are making an excellent argument. The higher US savings rate and lower US demand will improve our trade imbalance. This will be reflective in a stable and strengthening dollar. The dollar is not tanking like those that except higher inflation believe that it will.

Apr 24 02:10 PM

[Alphameister:]

Thank you for a fascinating, insightful article, superbly argued and well-written. It's possibly the best macro article I've yet found on SA. Thanks also for equally insightful comments in reply to other comments on your article, most of which clearly lack the depth of understanding so evident in your insights.

Fortunately, we are increasingly able to make global choices in our investments. My current investment focus is on China, which is not immune to factors affecting the US economy but is much better positioned to produce real corporate earnings growth well into the future.

Apr 24 02:49 PM

[kirkf:]

Arguments that monetary expansion won't lead to inflation sound similar to those that said the increase in housing prices was justified and wouldn't lead to a bubble.

Kirk

Apr 24 05:18 PM

[Angsthase:]

Very interesting article indeed.

However, I find it truly amazing that no one seems able to convincingly predict what a basic parameter such as the inflation rate will be over the next three years.

This article makes clear and, apparently, sound arguments that inflation will be small(ish). Other articles make equally, to me, sound arguments that inflation will be "large".

Why is that?

I remain amazed that macro econometric models are not able to convincingly predict, with at least some accuracy, where things will be in 2010.

I am an engineer - not an econometrician - and it obviously shows.

Is there any validity to MV=PT???

I get the idea that no one really knows.

Apr 24 06:47 PM

[capitalisth...:]

We do have models and they are pretty basic: if you increase the money supply you will have inflation unless V and T decrease in proportion.

It's amazing to me how many economists ignore this. It's equivalent to a physicist ignoring inflation.


On Apr 24 06:47 PM Angsthase wrote:

> Very interesting article indeed.
>
> However, I find it truly amazing that no one seems able to convincingly
> predict what a basic parameter such as the inflation rate will be
> over the next three years.
>
> This article makes clear and, apparently, sound arguments that inflation
> will be small(ish). Other articles make equally, to me, sound arguments
> that inflation will be "large".
>
> Why is that?
>
> I remain amazed that macro econometric models are not able to convincingly
> predict, with at least some accuracy, where things will be in 2010.
>
>
> I am an engineer - not an econometrician - and it obviously shows.
>
>
> Is there any validity to MV=PT???
>
> I get the idea that no one really knows.

Apr 24 09:52 PM

[capitalisth...:]

I mean gravity :)

Apr 24 09:53 PM

[IronMeteor:]

Great analysis. Amazing, actual analysis and not just a few hyped opinions.

The analysis you give is quite good and really does back up the common sense view that inflation is dead for now. But I will admit that this all depends on the status quo for the dollar and foreigners. Where as the velocity for the US consumer will stay at the new lower level, will the foreigners with US dollars continue to hold them or try and recycle them at a higher rate, thus negating the US consumer velocity drop.

Nobody can predict the future on that, but I favor the benign outcome as nobody has any vested interest right now to upset the apple cart and create a dollar panic. So the foreigners will continue to hold the dollars and the Velocity of dollar transactions will slow for all.

I also think the common sense view is easier to get. Why would consumers, who are losing trillions on investments and housing, losing jobs, health care, and their pensions, pay more for goods. They won't. You can already see it. Amazon's sales are climbing. Price is king. Their is absolutely no way that higher prices will stick right now. The Mets and Yankees can't even sale out their home games now after the montrous price hikes. They are now lowering prices, not raising them.

Can anyone explain how prices will climb in the next few years. Anyone. Please. I want a detailed outline of the process. How Fed printing gets into my pocket and makes me buy things that are higher and more importantly, makes the stores raise prices too. Wages aren't climbing, commodities are way down and seem to be stable enough. Where is this phantom urge to raise prices. Where and how.

For every dollar the Fed prints, the credit markets are destroying 3. For anyone who reads Doug Casey of the prudent bear, you should remember that the shadow banking system controlled credit creation, not the fed (that was true up until 2008). The fed was nothing compared to the shadow system. Now the shadow banking system is dead. So the Fed is printing like mad but its useless. They would have to print 10T or more to just keep it stable. They are so behind the curve its not even funny. Maybe in a few years they catch up, but not this year or next.

Again, please prove me wrong with a detailed write-up of how fed printing will make manufacturers raise prices, stores pass them on and consumers go ahead and pay them. I have trouble seeing it. It won't happen for a long time.

Apr 25 03:12 PM

[Minlita:]

Bailout money is being used by the banks to trade the market up in attempts to pretty up their financial outlook (and others) so they can raise more cash.
Inflation it’s going from the goverment to the banks and into the stock market. It hasn’t made its way to the economy….yet.
Does it even make any sense to fight it at this point but inflation but we it will end someday and end very badly.
Stock markets are in a rally for a long time, but the stock market doest runs on it’s own rules, we have to look to the underlying health of the business behind the stock, for national and world wide economic fundamentals they provide large influence.

Apr 25 06:54 PM

[Mark123:]

You forgot the part about the Japanese culture of saving, (not spending) which leads to low velocity... and the fact that they are a producer economy (not a service economy)... Oh-- and the minor detail that the Japanese govt was not in debt when their policies were instituted, while the US govt is buried in debt as our quantitative easing & "zero interest rate policy" started ... which negates your point---otherwise, good article...

Apr 28 11:12 AM

[Baboon:]

Buy DBC. It's like buying commodities with dividends.


On Apr 24 12:01 PM p church wrote:

> Since gold pays no dividends, there
> isn't much buffer against being wrong about deflation so risk/reward
> there doesn't appear attractive.

May 10 10:13 AM

[james50:]

Excellent point re: home equity loans. Always been two camps, savers and borrowers. If borrowers can't find credit, then savers will predominate and savings ratio goes positive without any change in anyone's behaviour. Of course, surplus savings means rates of return on savings should fall, hence downward pressure on rates. Savers can't live without those pesky borrowers, but may have to. Hence we may well have a return to low 19th century-style interest rates and savers having to live off their capital rather than rely on interest. Painful, but realistic if you don't want to take credit risk.


On Apr 24 12:01 PM p church wrote:

> What an interesting debate. The bottom line is we are trying to figure
> out what to invest in. Since gold pays no dividends, there isn't
> much buffer against being wrong about deflation so risk/reward there
> doesn't appear attractive. The sound arguments above would make it
> unclear which way inflation is headed. Oil, on the other hand, appears
> much more clear cut. A declining world supply and a temporary softening
> of demand - soon to likely resume to increasingly rising = a return
> to $75 or $80 a barrel. Over $100 seems very likely within a year
> or two. Regarding savings, the elimination of the home equity cash
> machines can be attributed, not the sudden prudence of America. Lasting
> deflation appears unlikely. Buy Oil, not Gold.

Jul 08 04:15 AM

[james50:]

Good comment re: impact of home equity loans on the savings ratio. There are always two camps, savers and borrowers. If borrowers can't find credit then the savings ratio will rise or go positive (if it was negative) - even if there has been no change in behaviour. Borrowers don't suddenly start borrowing less because they want to, they just can't borrow as much as before. The downside for savers is that they rely on these borrowers for their interest payments. If savers can't find credit worthy borrowers there will be a surplus of savings, pressuring interest rates. Savers (we?) may then have to go back to at 19th Century style (and earlier) environment where people have to live on their capital, not the interest on the capital. There is no free lunch, or rather no risk free rate of interest. Savers (we) will have to face up to the fact and economise accordingly.


On Apr 24 12:01 PM p church wrote:

> What an interesting debate. The bottom line is we are trying to figure
> out what to invest in. Since gold pays no dividends, there isn't
> much buffer against being wrong about deflation so risk/reward there
> doesn't appear attractive. The sound arguments above would make it
> unclear which way inflation is headed. Oil, on the other hand, appears
> much more clear cut. A declining world supply and a temporary softening
> of demand - soon to likely resume to increasingly rising = a return
> to $75 or $80 a barrel. Over $100 seems very likely within a year
> or two. Regarding savings, the elimination of the home equity cash
> machines can be attributed, not the sudden prudence of America. Lasting
> deflation appears unlikely. Buy Oil, not Gold.

Jul 08 05:38 AM