Laffer Getting Ready for Inflation and Higher Rates

There is an excellent opinion article in the Wall Street Journal today by Arthur Laffer (see WSJ article). In the article, Laffer discusses the increase in the monetary base, and how in the past 95% of the monetary base was composed of currency-in-circulation. Even with the recent unprecedented increase, cash-in-circulation has risen only 10%, now making up less than 50% of the monetary base, whereas bank reserves have increased nearly 20-fold.

Granted, an increase in bank reserves was needed as a result of the liquidity issues of 2008 in order to make it possible for banks to begin lending again, but the balance has shifted too far. Laffer points out that banks will no doubt continue to make loans until they are once again reserved constrained.

Currently, as banks make more loans and put more money into the system, the growth rate of M1 (currency in circulation, demand deposits, and travelers checks - see Wikipedia article) is now around 15%. This of course will result in higher inflation and higher interest rates. As mentioned by Laffer,

In shorter time frames, the expansion of money can also result in higher stock prices, a weaker currency, and increases in commodity prices such as oil and gold.

Does this market situation seem familiar? Unless the Fed acts to reduce the monetary base, which appears unlikely anytime soon given that there is no easy approach or outcome, it appears likely that the Fed will continue to lose control over rates (see previous post), and the markets will continue to tip towards inflation (see additional previous post). Plan accordingly.

Comments

[Larry House:]

Laffer isn't the only respected voice saying this. It is just common sense. Has the government ever gotten this right in the past? Many want to point to past market movements and say today is like this or that. What about the government? The past shows the government always gets the timing wrong on easing and tightening. Why should this time be any different?

Jun 10 03:19 PM

[Mad Hedge F...:]

bring them on! Just another update on my core short in long dated US Treasury bonds, the TBT, which hit a new high for the year of $60, up 72% from my initial call (www.madhedgefundtrader...). The nine to eleven year note auction went off OK, despite its enormous size. What drove the yield on the ten year to a seven month high of 3.99%, the 30 year to 4.67%, and herded buyers into the TBT was the May US budget deficit of $190 billion, an all time record, despite massive inflows of income tax revenues. The news also gave the dollar a steroid shot and sent equities on a 200 point intraday swoon. If high rates and $70 crude don’t go away, they are going to kill the stock market. Everyone is holding their breath for the 30 Treasury bond auction tomorrow. The time to pay the piper is coming, and his rates are going up.

Jun 10 04:39 PM

[Long Silver...:]

M*V=P, right? So the only way to tackle this problem is to regulate Velocity. How do you do that? By imposing a low-rate adjustable clearance fee on payment transactions and by regulating the time for clearing funds. Thoughts?

Jun 10 07:36 PM

[Mistrofan:]

We really have to clarify this inflation/deflation subject/ My opinion: we are seeing and we will see deflation in real economy 'till the end of 2010. That being said, history proves that smart money are going into inflation "protected" assets way before the inflation starts (on average 12 months before). That is proved by the movement in TIPS and commodities in the previous deflationary cycles from the past. What I am just saying is that both those in the deflation camp and those in the inflation are equally right. Is just a matter of looking at the same thing from 2 different perspectives.

Jun 10 10:23 PM

[CaptainJJack:]

Arthur Laffer's "supply side" nonsense has done more damage to our long term future than any other economic idea in recent history, and no idea is more responsible for the mess we are in today.

If lowering the tax rate generates so much more revenue, why don't we drop it to zero and generate a huge surplus?

Laffer has zero standing, in my view, and the sooner we leave him to the dust bin of history, the better.

Jun 11 09:16 AM

[Long Silver...:]

What's interesting about Laffer's article in the WSJ is that it now parallels similar warnings made by Peter Schiff a while back, and which Laffer publicly "laffed" at and ridiculed. He's not laffing now...

Jun 11 01:18 PM

[Danny Newton:]

The way I read the Laffer Curve, there is a point of optimal taxation that when exceeded reduces revenue. It only makes sense to reduce taxes if you are on the wrong side of the curve. There is also a presumption that if you are on the low side of the curve where additional taxation might be tolerated, the government would not spend it on stupid stuff. I think the last time that happened, the Interstate System was built with a resulting large increase in productivity for everyone. Public health spending that nearly got rid of polio would be another example.

Basic government to protect property rights and aquire the greatest good for the greatest number is not a problem. Dropping the tax rate to zero would run us back to a war lord and fifedom economy like Afganastan or Somalia,

Jun 11 08:23 PM

[Westcoaster:]

Boy, I sure hope you inflation bulls are right. That will mean spending and incomes will be growing again. Inflation is the product of money supply and velocity. Everything I look at shows very low velocity and droping incomes.

Jun 12 07:22 PM