Why Inflation Never Came

Includes: GLD, IAU, SLV, TBT, TIP
by: The Market Flash

A generation of economists and students of macroeconomics were taught that the Quantity Theory of Money described the relationship between money and prices in the economy. The primary equation for the Quantity Theory of money is:


is the total amount of money in circulation on average in an economy during the period, say a year.

is the transactions velocity of money, that is the average frequency across all transactions with which a unit of money is spent. Velocity is derived from the Money Multiplier which arises from a fractional reserve banking system. When a bank lends money to a business from deposits its customers make, that money can be paid as salaries, re-deposited, and lent out again, and so on. So a given unit of money can change hands and take part in many more transactions than if all banks had to keep 100% of their deposits on hand.

and are the price and quantity of the i-th transaction.

is a column vector of the , and the superscript T is the transpose operator.

is a column vector of the .

This equation is often referred to in the form:

This equation was taken from Wikipedia and modified by me for brevity and clarity. Don't be put off by the math; this article doesn't require a high level of understanding of math. The equation says the amount of Money in circulation (M) times the (V)elocity of Money equals the sum of all the (P)rices times all the (Q)uantities for all transactions in the economy for a given time period. Money in circulation is sometimes call High Powered Money. You can see that if V and Q stay the same, P (Inflation when rising) will go up if M goes up.

The Quantity Theory of Money is now under fire in academia because changes in technology and innovations by financial institutions have rendered the theory a less than complete view of the world. This has many important implications for investors from a macro point of view. Here is a statement that describes the Quantity Theory of Money from an article by Singh and Stella that I will reference below.

"Textbook presentations of the actual US monetary policy transmission mechanism frequently characterize it as follows:

  • The Federal Reserve uses open market operations to inject or withdraw commercial bank reserves (High Powered Money, the "M" in MV=PQ).
  • These banks then create money via the 'money multiplier'. "

The statement about High Powered Money in special font is mine.

Singh and Stella state in this article that the "Textbook presentations" have shown some real problems since the financial crisis of 2008 and they make their case in this article.

So let's take a step back here and try to understand the thought process that many intuitive investors and investors with more advanced training in finance and economics were having about inflation expectations. The Fed has been increasing High Powered Money for a long time, but I think many of us became very aware of it after 2008. One way you can be sure High Powered Money has been increasing is to look at the Fed Balance Sheet. The Fed increases the money supply by buying Treasuries and MBS with money that did not previously exist. Up until 2008, the Fed never had more than a trillion dollars of Assets. As of the writing of this article the Fed balance sheet holds more than three trillion dollars of assets.

Basic intuition and the Quantity Theory of Money said that if Fed was printing money (Quantitative Easing), inflation would follow. Well-known investors like Schiff and Rogers thundered that the Fed was out of control and there would be hell to pay. Many of these investors thought that protection in terms of "hard" assets like GLD, SLV, and real estate was called for. Inflation (P going up in the formula) is always a component of interest rates (Nominal Interest Rate = Inflation + Real Interest Rate) so a derivative thought for those worried about the Fed increasing High Powered Money was that interest rates would go up. In a case like that, a product like TBT (short Treasuries) would be useful to own and being long bonds would be a bad idea. When the inflation didn't happen, many of us thought it was because Money Velocity was dropping. The Singh and Stella article addresses why we didn't see inflation and it wasn't just because Money Velocity was dropping.

I encourage you all to read the Singh and Stella article, but I will summarize it by saying that they feel that the influence of the legacy banks (Citibank, B of A, JPMorgan, etc.) is less important to money creation than it used to be. They claim there are a larger number of financial institutions that create money now and that good collateral serves more the role of the constraint on the money supply than the older High Powered Money. The article implies that the fundamental components and relationships on the left side of the equation (MV) have changed significantly in the last 20 years. My take on this is that advances in technology have made paper money less important, increased the speed at which money changes hands, allow people surrogates for money like SPDR Gold Shares (NYSEARCA:GLD), iShares Silver Trust (NYSEARCA:SLV), and bitcoin, and led to people holding their money in more places than just a bank checking and savings account. To quote from their conclusion:

"Post-war US credit expansion - and, by inference, inflation-has not been dependent on an expansion of bank reserves and there is no reason to expect there will arise now a causal impact of the latter on the former. The liquidity fulcrum of a modern financial system is more complex than the monetary base and its size is determined by market conditions which continue to show signs of strain despite comparatively massive central bank injections of bank reserves."

So what does this mean for investors? I would not go out and buy bonds now. Even if Fed money printing does not cause inflation, the Fed withdrawing from its purchase of Treasuries and MBS to the tune of $85 billion a month will probably cause interest rates to go up. If you are short bonds Proshare Ultrashort 20+ Treasuries (NYSEARCA:TBT), waiting for inflation to appear, you may have a long wait. Timing the Fed withdrawal of QE may be more fruitful. If you are stock piling hard assets (long GLD, SLV, or physical precious metals) and waiting for inflation, this article implies that inflation may not come.

Many people say that all this money printing is what is behind the rise in the stock market. I personally have never read any compelling explanation of how the Fed printing money makes the stock market go up. The Singh/Stella article does talk about asset displacement when the Fed buys Treasuries/MBS for cash from money center banks but does not say how that affects the stock market. One theory in Finance is that stock prices represent the discounted present value of all future earnings for all publicly held corporations. If you believe the Fed can keep current interest rates this low for a long time (say 10 years), then you could argue that stock prices are up because the discount interest rate is down, driving the present value up. I haven't seen this argued in very many places.

Some of us question the integrity of a system where the Fed can create substantial money out of thin air for short-term political or economic gain. But as I have mentioned before, the ability of the Central bank that controls the world's reserve currency to create money may be substantial. This is not the free lunch it appears to be. If Reserve currency status were ever to be lost, there is a long period where the former reserve currency is repatriated to the issuing country that causes economic dislocation. This dislocation was suffered by the UK when the British Pound lost reserve currency status in the 1930's and 1940's.

The intuitive appeal that Fed money printing must have the bad consequence of inflation at some time seemed common sense to many of us. We waited a long time and that inflation did not appear. A new theory (Singh/Stella) is now being presented concerning the effects of Fed money printing. It's important that investors incorporate new ideas that explain the world as it is into their investing processes. Adjust your portfolios accordingly.

Disclaimer: This article is intended to be solely informational and does not represent a recommendation to buy or sell any security. The information in the article is believed to be accurate but you are advised to do your own research and exercise your own due diligence before taking any action that affects your financial future.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author holds a hedge position of hard assets in his portfolio, not GLD or SLV.