Which Inflation Is It Anyway?

There is a debate building around inflation. The outcome of this debate will determine the direction of interest rates and credit creation. By extension, many commodity prices, especially precious metals and energy, will get direction too.

This past week saw the release of the US CPI reading for June with a "headline" increase of 1.1%. Even the much derided "no heat-no eat" Core Rate that excludes food and fuel was up 0.3% for the month.

The 12-month CPI gain in the US is now 5%, and even a sustained pullback in oil prices won't cause consumer inflation to retrench much this year. CPI is the only inflation measure many people ever focus on even though it is so heavily massaged it borders on fiction. Nonetheless, that is the headline number and the one that consumers are supposedly thinking about as they wonder what sort of wage increases they need to keep up. Likewise, businesses watch the number closely, and try to plan ways to pass on cost gains without losing customers.

Left unchecked, that sort of thinking could ultimately lead to a wage/price spiral that no one who lived through Paul Volcker and his G7 colleagues wrestling inflation to the ground in the late 1970s wants to revisit.

As important as the CPI number is to perceptions of inflation, many gold followers may now find themselves in something of a predicament using it gauge future price moves. Most fans of the yellow metal are, implicitly or explicitly, of the monetarist economic camp. They view changes in the supply of fiat currency as the determining factor for changes to inflation.

Taken further, hard money monetarists view all fiat currency as ultimately doomed stores of value - politicians and bureaucrats will always fall back on the printing press when times get tough and thereby erode the value of that currency.

An ever expanding supply of fiat currency chasing the same basket of goods means prices will inevitably be bid up, at least as measured in that fiat currency. Milton Friedman, free marketer and champion of the monetarist view, put it most succinctly when he stated that "inflation is everywhere and always a monetary phenomenon". We're not sure that is true, but if it is, that still leaves some complexity in deciding what "money" is.

Monetarists have different views on which money supply figures matter, and often disagree violently on the import of statistics. Nonetheless, few would argue that the changes in "narrow" money supply (M1 and M2) over the past few months speak to a scary trend, though a different one than you might have read in the headlines.

In the US, M2 (cash, current account deposits, and short-term savings deposits) began falling off a cliff earlier this year. Growth in M2 spiked earlier in the credit crisis, reaching16% near the end of the first quarter. It has since reversed course with a vengeance - M2 contracted in the latest month.

Each month brings more negativity in the banking sector and tighter lending conditions. Changes in bank credit, a broad proxy for lending and money supply changes make for grim reading lately. Those too have dived, going from a growth of 12% last year to an 8% contraction (so far) this year.

If you can't borrow, you spend what you have, and "what you have to spend right now" would be another way of defining M2. This 8% contraction in bank credit is the steepest fall for it in 40 years. This doesn't bode well for growth figures given credit creation (lending) in a fractional banking system is a main conduit for money creation.

The underlying cause of the contraction is, presumably, that banks are worried about having even the fraction of deposits required of them to be considered solvent.

Some monetary purists, we know, will point to the broader M3 measure (which the US no longer publishes) that rose rapidly last quarter. We think observers that view the recent surge in this measure as temporary are right. Most of the growth probably represents companies fully drawing down lines of credit before the banks cut back on them. It's not "new" lending in the strict sense of the word, and does not therefore represent new stashes in longer term accounts being put to use.

So what does one make of a situation like this?

On the one hand, headline inflation is rising rapidly. On the other hand, you would be hard pressed indeed to find an economy that managed to grow through a period when credit was contracting at the speed it currently is.

There are still plenty of inflation hawks out there, including a number of US Fed Board members. The ultimate hawk these days is Jean Claude Trichet, head of the European Central Bank, but money supply growth is diving in Euroland too.

We've never pushed the money supply aspect too hard ourselves. We haven't found it was a great predictor of price inflation, even though monetarists would tut-tut and argue those money supply growth rates are inflation. Big changes in money's growth rate, like the one currently taking place, do tend to be significant however.  That's why monetarists were among the first to scream "fire" while most were still congratulating Greenspan for the low lending rates that helped create the housing bubble.

The contrary view from assets…

In order to make sense of the current situation you have to look at assets as well as consumption. In addition to rocketing CPI, this is also a period of collapsing asset prices in large part generated by the backlash from that housing bubble. The question for markets is which set of price changes should it be responding to?

Based on the unprecedented scale of asset price falls we think there is little doubt they will trump headline inflation numbers. We don't see how the uptrend in consumer prices continues when the falling value of nest-eggs has to be generating widespread demand destruction. The evidence that price inflation is spreading, to be expected when energy costs that underlie most goods creation are a large part of the primary inflation, is likely the end of game of this inflationary round playing out.

With unemployment in the US rising it is difficult imagine wage increases gathering steam. Wage-pushing higher in response price gains has always been the mechanism that imbeds higher inflation and makes it so hard to control. Europe, with stronger work laws and higher unionization has more potential for wage inflation, so perhaps Trichet can be excused for his hawkish stance.

In the face of these forces, and the dropping money supply figures, there is only one likely response. Bernanke is a student of the Depression and most agree that credit contraction at the wrong time helped to create and prolong that disaster. Banks are so reluctant to lend right now that we can't imagine Bernanke adding to the misery. He's going to keep the lending lines open and there is little chance of a rate gain even in the face of high CPI numbers. Indeed, it's increasingly likely the Fed will cut, though the Fed Rate is already so low there isn't much ammunition left there to use.

We've seen and made comparisons to the 1970s, but on the credit side things look increasingly like the 1980s Latin American debt crisis. That crisis made virtually every major bank in the US technically insolvent for several years. In the end, people just looked the other way while a steep yield curve eventually allowed most banks to earn their way out of trouble while the most incompetent banks were allowed to fail.

Japan went though a similar experience in the 1990s, though it took longer and was more painful because no one owned up to the problem for years. Japanese banks, not ironically, have had little exposure to this housing bubble.

There is going to be a lot of anger over bank rescues and recapitalizations. Many will think, rightly, that the idiots who created the mess are getting off too easily. Nonetheless, the real danger we see is deflation if lending doesn't pull out of its dive soon.

The move last week to curtail shorting of bank shares is just one of many moves we're likely to see to try and change sentiment. Going forward, there may yet be rule changes to make it tougher to 'speculate' on things like oil prices. We hope this doesn't come to pass since we're pretty sure most spec money is on the short side of the oil market right now. For all the credit problems right now there is still a lot of money in the world, though a good chunk of if is outside the US.

We expect continued heavy spending on infrastructure in many regions, and that they could be joined by the US itself post election. The US needs that spending anyway and infrastructure has been proven to be some of the most effective "make work" money.

One of the secrets to China's success has been its willingness, and lack of impediments, to huge funding of money on roads, power, and communications. The same thing is now happening in Russia, which has horrible infrastructure but gushers of money thanks to oil. India needs it desperately, too, if it is ever to pace China on economic growth. Infrastructure spending means "stuff" should to continue to be a winning sector, though maybe not next week or next month in terms of share prices.

The markets' perception is so negative now that winners are simply being sold, but even if your portfolio seems to be telling you otherwise, the materials sector is one of the few that actually has had pricing power lately. Commodity prices will continue to be historically strong, but it simply will take a better market environment for anyone to care, and to take notice that things like zinc and nickel are selling below marginal production cost. There may be more bargains before the retrenchment in equities is over, but bargain hunters will be rewarded if they choose companies with growing resources and the ability to weather the storm.

If shrinking credit markets continue to be the focus, the Fed will continue to be accommodative even while true-market interest rates (the spread) stay relatively high. Stopping stupid investment banks and trying to rescue homeowners will mean more debt expansion for the US government. Combined with loose monetary policy, that will keep the US Dollar relatively weak. That will be a boon for gold and silver, which have held up well in even in the face of plunging oil prices. Gold appears to have again decoupled from oil, and may even decouple from the Dollar again as long as traders feel the need for a place to hide.

Whatever one thinks about peak oil and the power of speculators there is no doubt that oil prices falling farther is the best possible scenario for the economy at large. It would provide the quickest improvement to discretionary consumer spending, not to mention peace of mind.

The next few months will be rocky. Let's hope the monetarists win the argument - and that this time the liquidity tap is eased down before the next bubble forms.

Stock position: None.

Comments

[paulsjj:]

The record of the Fed & the Treasury & the Congress is clear: One (1) 1913 dollar is worth $22.10 2008 dollar.

2008 Aug 01 09:38 AM

[MarvinMBA:]

I agree but to put it in the real world this is what we have happening:
M1: People are losing jobs...high energy and food costs...less borrowing and reduced RE evalatuations..in summary people have less pocket money to spend.
M2: People are using savings to survive or try to maintain their lifestyle.
M3: The Fed is trying to replace the securities that are losing and lost mark to market for the lenders/brokers.
This is what is going on in a nutshell.

2008 Aug 01 10:02 AM

[Shakybarnes:]

"The record of the Fed & the Treasury & the Congress is clear: One (1) 1913 dollar is worth $22.10 2008 dollar."

And that matters why? Did you bury a box full of 1913 currency in your back yard?

2008 Aug 01 10:51 AM

[Pent up demand:]

It matters because it's a form of theft. The lost value didn't just disappear; it went to those who got the newly minted money first.

2008 Aug 01 12:17 PM

[Jason Rines...:]

You are correct Pent Up.

2008 Aug 01 12:46 PM

[JasonC:]

Nonsense - the change in the exchange value of any asset due to economic activity by others is not "theft". Nobody guarantees the exchange value of anything will remain unchanged; nobody could, if anyone has the slightest economic freedom. You are responsible for picking your asset position, and you are responsible for the consequences in purchasing power over time. If you think banks have it easy under fiat money, buy bank stock instead of lending banks your deposits. Hint - they don't. Or use diversified portfolio investment or real assets as stores of value, not a transactions currency.

I insanely dislike this tendency to criminalize the side effects of other men's freedom. It is just a new version of the old hatred of capitalists and "usurers", and it leads directly to the destruction of liberty, economic first but not limited to that. Men are free to engage in credit transactions, including ones that expand money substitutes.

Every successful or unsuccessful entrepeneurial action on a sufficient scale, changes the exchange value of everyone else's holdings. Period. Financial actions are no different in that respect than big investments in this or that sector making assets within it more valuable compared to assets outside of it.

2008 Aug 01 01:19 PM

[E.D. Hart:]

Globalization makes things different this time.

With China, Japan, Middle East countries increasingly taking their dollars and putting them to use in other asset classes, including commodities, we will see inflation here in the US, while wages fall and unemployment rise.

It will be the worst of all possible worlds for the US. A weaker dollar, and higher unemployment, as well as stagnant wages.

The experts will tell us that inflation should be falling because wages aren't rising--so don't worry.


Foreign governments and individuals control HALF of the total dollars in circulation, a little more than 7 trillion.

These dollars are starting to come home to roost--driving up inflation here. It is the unwinding of the exporting of inflation that we have been so successful at the last three decades.

Credit will continue to contract, and inflation will continue to accelerate--and people will shake their heads and wonder "why?"

2008 Aug 01 03:12 PM

[SimonS:]

JasonC - If money is to be used as a store of value, its supply should correlate with the amount of goods and services in the economy. Otherwise, you would get an imbalance that triggers price increases because it has been devalued (think of what's happening in Zimbabwe.) In gold standard, price actually decreases as new goods and services get created with virtually constant money supply.

You can still borrow money in a full-reserve banking system. It's just that the lender cannot withdraw the money in exchange of interests until the debt gets repaid. In contrast, fractional reserve banking system can lend out up to 90% of deposits which is equivalent to expanding the money supply 10 times.

2008 Aug 01 04:56 PM

[JasonC:]

Simon S - I've heard the whole song and dance a million times from experts, it is still a total crock. You want gold store of value, buy gold already, nobody is stopping you. What you want instead is to have the gubmint run around stomping on everyone freely engaging in credit transactions on their own terms. I want flexible banks, not a gold straightjacket. No, you do not have any prior right to ongoing deflation enforced by jackbooted gubmint goons. If one entrepeneur wants to accept the mere promises of another, it neither picks you pocket nor breaks your nose. It is merely other men's freedom. And your wanting to abolish it because you think it inconveniences you is completely unjustified. Every time you spend a dollar on anything without my prior approval and at my direction, you bump around the exchange value of everything I could possibly own. But I don't object or call it stealing from me, because it is your freedom, not mine.

If you think bankers have it easy, join them. If you know they don't, stop slandering them. If you think fiat money stinks, get through the next ten years paying for everything in blueberry scones. You are benefitted by a perfectly functional transactions medium and freely use it. This isn't Zimbabwe, and pretending it is, is merely lying.

Also, in case nobody noticed, the Fed tightened over 3 years ago, and M1 (the measure it directly controls, limited by its own balance sheet size) hasn't moved an inch since then. The Pauleans are singing from an invariant script - don't bother them with the mere facts.

2008 Aug 01 08:08 PM

[Alex Filonov:]

It's hard to explain people right now that deflation is much more dangerous than inflation. There are a lot of people around who lived through inflation of 1970s. And almost none who lived through Great Depression. Some people even call what happened in 1970s 'hyperinflation'. Wrong! Hyperinflation is double digit inflation in a month, not in a year! Anyway, the problem with deflation is that there is no cure for it. It can last decades (look at Japan) with no end in sight. And you can think that government can print enough money to fix it, but it doesn't work if this money is not getting spent. Japan tried to print money, they tried different stimulus packages, and still nothing works. That's why I'd prefer inflation now to deflation a little bit later. And don't tell me that inflation bad, I lived through 30% a month inflation. You have no idea what's it like, I do.

Uncle Ben, please print more money while it can still work.

2008 Aug 02 12:05 AM

[shopa:]

Cheaper oil may help in the short run, but we need to burn less CO2 in the long run.

2008 Aug 02 09:54 AM

[BrunoT:]

JasonC. Does it occur to you that the govn't IS involved? They're out there bailing out everyone and his brother with OUR money. When they spend more than they have taken in in taxes, they do ROB the savers by debasing their dollars. They have privatized profit and socialized risk/loss. This is a receipe for total ruin and collapse of the economy. They also caused much of the problem pumping cheap money into the economy when the market would have set rates much higher left to its own.

Also, the author, while mentioning m1,m2 etc, forgets that many dollars leaving bank accounts here and reducing those numbers are not disappearing, they are winding up in China and Saudi Arabia's pile of dollars. So money supply of dollars in the global economy isn't just domestic. Dollars destroyed through default are gone, and benefit few (except the borrower, who got something for nothing). But this is not so much a 'deflation" as a return to normalcy from an era of insane borrowing. It has to happen. It can't continue. Debt based living when the debt is used to consume is non sustainable.

Muddling Investor: Deflation may be bad. But not to everyone. If a retiree has saved $1M through hard work over his life, he's gonna vote for deflation that allows him to live longer on his stash, rather than inflation, especially hyperinflation, that quickly destroys his savings in a few years. Also ask a lender which he prefers. If he's loaned out money at 5.5% on a mortgage and hyperinflation occurs, he's getting paid back in near-worthless dollars 10-30 years out. Or someone who leases cars or other items. If the residual is set at $10,000 on an item, but inflation makes that item worth $150,000 by lease-end, and the customer simply purchases it for a song, he loses bigtime, as his valuable asset is exchanged for debased dollars.

2008 Aug 02 10:07 AM

[BrunoT:]

JasonC. Let me add that your entire fractional reserve system IS government action. When they sanction a bank to create money out of thin air in a loan, with no corresponding goods being created, that is monetary inflation and that robs others of the value of their money. So who's the one pushing for the govn't to inhibit others' freedoms?

2008 Aug 02 10:12 AM

[ozzy43:]

JasonC: hilarious. Millenia of human history mean nothing to you it seems - hold no lessons whatsoever. Fiat money throughout history has served as the vehicle of inflation to serve the purposes of the printers and those regimes have invariably collapsed under the weight of their paper money (but they had VERY flexible banking - right up until the end).

In truth, this has nothing to do with entrepreneurship. It has to do with the fundamental soundness of the monetary system. Have you looked around lately? It is precisely this soundness that is crumbling even as we speak - and for the reasons Simon and other cite, among others - hard to imagine how more blatantly obvious this could be. But let's not bother YOU with facts, either from the daily news, or from history. Facts are, after all, inconvenient things when they get in the way of 'flexible banking'.

2008 Aug 02 10:29 AM

[ozzy43:]

Regarding this assertion:

"We expect continued heavy spending on infrastructure in many regions, and that they could be joined by the US itself post election. The US needs that spending anyway and infrastructure has been proven to be some of the most effective 'make work' money."

I am aware of no proof along these lines whatsoever. This is nothing but Keynesianism - an ideology which insists that economic stagnation and inflation can *never* exist side by side. And yet - we know it does. Thus, the underpinnings of this form of economics is fatally flawed.

Bastiat's 'Broken Window' parable is on target here. Money coercively extracted by the government and spent on 'make work' projects is money that is NOT being allocated by the market, thus represents a reduction in efficiency, and thus a reduction in net productivity, compared to a situation where government did *not* extract and spend that money. This is not a difficult concept, yet it is apparently not understood by those analysts who cheers government spending.

2008 Aug 02 10:35 AM

[allan skye:]

Well put ozzy 43!This is also a form of malinvestment if overindulged in,which of course causes bubbles in its own way and can depress profitability in the private sector and therefore proves the adage that public spending displaces private spending if indulged in excessively.

2008 Aug 02 11:02 AM

[JasonC:]

Bruno - no, banks issuing loans and others accepting their promises as money are not "government action". Banks were doing it themselves long before government had anything to do with it, and the Fed limits how much of it banks do. It does not create their ability to do so. Allowing a perfectly voluntary transaction to occur isn't government action, any more than not nuking New York City is government action. Moreover, merchants were doing the same before banks existed. Gratuitous credit is a creature of the freedom of merchants, not of government action.

2008 Aug 02 11:53 AM

[JasonC:]

Ozzy - you do not appear to know anything about millenia of human history. In case everybody forgot, the reason "debasing" is called "debasing" is because governments readily inflated metallic currencies long before anyone dreamed of paper ones. The power of governments to act in short term or stupid ways isn't a function of the monetary system chosen, but of the specific policies of each government at each time. And you can't remove that power with an ideological line.

Second on the present financial situation, all it proves is that financial crises are normal. They can't be abolished and it is a mistake to try. You only destroy human freedom and the creation that precedes and follows the rearrangements required in the smashes. That there will be bubbles and crises and smashes, is an unavoidable consequence of human freedom, which includes the freedom to screw things up. Take away the freedom to screw things up and the government will screw them up for you, that is all.

Where there financial crises under metallic monetary systems? Of course. "But if you outlawed all forms of credit without 100% commodity cover, then..." then nothing. The value of the commodity cover fluctuates. The value is one thing and the commodity is another. The value refers to an entire state of the world and of expectations about future demand, which can always be falsified by sufficient forecast errors by entrepenuers.

Also, you can't abolish gratuitous credit without abolish most economic freedom. It was created by international merchants using bills of exchange, beyond the scope of governments - and it would be again. You'd have to chase everyone all over the world and jail them for issuing or accepting other men's IOUs. They always will, because sound IOUs work. They will always leave problems, because telling the sound from the unsound is hard.

There is no mythical way to wave away the possibility of financial crises. Everyone pointing at one and demanding that we give up another freedom is a snake oil salesman peddling a more intrusive government. Yes, I said a more intrusive government - there isn't anything libertarian about a particle of it. Free banking is a reasonable libertarian position. Making credit illegal is not.



asonC: hilarious. Millenia of human history mean nothing to you it seems - hold no lessons whatsoever. Fiat money throughout history has served as the vehicle of inflation to serve the purposes of the printers and those regimes have invariably collapsed under the weight of their paper money (but they had VERY flexible banking - right up until the end).

In truth, this has nothing to do with entrepreneurship. It has to do with the fundamental soundness of the monetary system. Have you looked around lately? It is precisely this soundness that is crumbling even as we speak - and for the reasons Simon and other cite, among others - hard to imagine how more blatantly obvious this could be. But let's not bother YOU with facts, either from the daily news, or from history. Facts are, after all, inconvenient things when they get in the way of 'flexible banking'.

2008 Aug 02 12:03 PM

[bowman711:]

One aspect of this I haven't seen mentioned is the impact of having gone from a production economy to a consumption economy. When an economy is focused on production, the expansion of credit is limited by the need for selling the products. It is no use to borrow to expand production if there are no new customers.

In contrast, in a consumer based economy, the expansion of credit is 'desirable' to enable the consumers to keep on consuming. Easy credit enables the consumer to buy and buy and buy more. That makes it 'desirable' for manufacturers to borrow to expand production to meet the inflated demand.

I think this change, from a production to a consumption focused economy in the last generation, is no small part of the predicament the U. S. economy finds itself in today.

2008 Aug 02 12:22 PM

[Isnt_It_Jus...:]

The feed back loop in the global financial system, now occurring, is to place a governor(brake) on Americans' (the source of $s) ability to continue consuming "stuff" where there is global demand (e.g. excluding US MBS's, etc) and this stuff will continue to get more expensive, when priced in $s, in order to cause this demand destruction from Americans. Thus the only stuff that is going to deflate in price America is stuff that only has local(US) demand (i.e. houses, MBS's, CDO's, gardiner's wages, you get the idea).

2008 Aug 02 02:05 PM

[Isnt_It_Jus...:]

Sorry, that last sentence should have read:

"Thus the only stuff that is going to deflate in price in America is stuff that only has local(US) demand (i.e. houses, MBS's, CDO's, gardener's wages, you get the idea).

2008 Aug 02 02:09 PM

[John Lounsbury:]

Great comments discussion.

Let me add a summary:
List (albeit partial) of things currently inflating:
Food, industrial commodities, energy. Of these, only food is predominantly U.S. produced (owned) for U.S. consumption.

List (also partial) of things deflating:
House values, credit securities value, stocks, dollar value. All of these are significantly U.S. owned.

We can not turn around our economic fortunes until there is a better balance between our ownership of things deflating vs. things inflating.

2008 Aug 02 04:15 PM

[allan skye:]

Regarding promises to pay,letters of credit etc .Several points- People stop believing the promise to pay the bearer when the bank prints too much extra money unbacked in an easily understood way -which leads to financial crisis.Politicians do have a role to play in keeping the belief going.One of the first acts of William Wallace in the 10th century apon becoming protector of Scotland was to bring Scottish wine merchants to court to pay their supplyiers in Bordeaux after they defaulted on their accounts and alot of reassurance was needed before they would let the scots have any more wine on credit.What a very high standard of writing on this comments page I must say!

2008 Aug 02 04:57 PM

[Gigem77:]

The money supply is expanding. M2 hit a new record in the latest reporting period. So where are you getting your information?

www.prudentbear.com/in...

M2 (narrow) “money” supply surged $48.7bn to a record $7.747 TN (week of 7/21). Narrow “money” has expanded $284bn y-t-d, or 6.8% annualized, with a y-o-y rise of $468bn, or 6.4%. For the week, Currency increased $2.4bn, and Demand & Checkable Deposits jumped $16.1bn. Savings Deposits rose $11.8bn, and Small Denominated Deposits added $3.2bn. Retail Money Funds jumped $15.2bn.

2008 Aug 03 07:22 PM

[Alex Filonov:]

To BrunoT: 'if a retiree has saved $1M through hard work over his life, he's gonna vote for deflation that allows him to live longer on his stash, rather than inflation, especially hyperinflation, that quickly destroys his savings in a few years.'

If a bank where retiree is keeping his/her money goes bust, he/she loses everything (but 100K insured by FDIC). In deflationary environment, banks go bust. If that retiree keeps money in stocks or bonds, he/she loses money, because stock and bond markets go down in deflationary environment. Everybody (well, almost everybody) loses money in deflation. Even lenders, because they get higher returns only on returned loans, and bankruptcies sharply increase in deflation. If your debtor is bankrupt, you get back much less than you loaned. Just read about Great Depression and Japanese Great Depression. In the beginning of 1930 (severe deflation) about 4000 banks (lenders) in US went bust.

2008 Aug 04 11:30 AM

[Alex Filonov:]

Correction: I wanted to say that in the beginning of 1930s about 4000 US banks went bust.

2008 Aug 04 12:30 PM