Seeking Alpha
, Economic Leads (100 clicks)
Long/short equity, value, contrarian, investment advisor
Profile| Send Message|
( followers)  

Inflation will likely decline before it surges. A case for hyper inflation is premature. While phenomenal growth in bank reserves inflated the monetary base over the last 4 years this expanded potential for money growth has not yet led to actual high money growth. Over the last 4 years the money supply as measured by M2 has grown at a pedestrian 6.6% rate.

Milton Freedman said inflation is primarily a monetary phenomenon. The growth in M2 has a more robust influence on inflation than any other variable I have found. The rate of M2 growth over 2-year periods has a significant correlation with the year-over-year inflation rate 32 months later. The chart below shows the relationship.

(click to enlarge)

Money growth has a bit of a curvilinear relationship with inflation where growth below 8% has a more modest effect on inflation, while money expansion above 8% begins to have an accelerated impact on prices. You can see this in the best fit curve in the scatter plot above.

The impact of money growth will have downward influence on inflation until about November 2013. Despite all the easing by the Fed, the 2-year growth rate of M2 fell to 3.2% in March 2011 and the 32-month lag time means less pressure on prices for another year. Since then money growth has accelerated to 8.4%, which would be consistent with inflation of about 4.5% around mid 2015.

There are of course other variables that impact the general price level. The second most important one I have found is the trade-weighted dollar index. Smoothed versions of these two leading variables along with a couple of others make up the model below.

(click to enlarge)

One of the variables in the model has a much shorter lead time, so the model only looks out to March 2013 and suggests inflation will be down to 1.3% from the current 2%. In the last 5 years inflation has been much more volatile than the model so the blue line jumps above and below the red line in the chart. This is largely due to food and energy swings. Fluctuations in the core rate of inflation over the last 5 years have been tamer than a similar model predicting the core rate below.

(click to enlarge)

This model suggests core inflation will drop from about 2% now to about 0.9% in June 2013. While I don't know what future values for other variables in the model will be yet, the M2 component suggests disinflation will continue into November of 2013.

I suspect the core rate will head down toward or below 1%. Volatility in the headline rate could briefly take inflation down close to 0%, especially if there is a recession, which I consider somewhat likely. After inflation bottoms perhaps toward the end of 2013, I expect it to rise somewhat rapidly. In the last couple of months M2 has been growing at about 9%, which if it continued would imply 5.1% inflation.

In recent years inflation as well as the model's forecast of inflation have been lower than the rate suggested by M2 growth. These other factors may bounce back in a couple of years and push the forecast inflation above money that growth on its own would suggest. Money growth must be watched closely because the expanded monetary base creates huge potential.

This inflation forecast implies long-term Treasury bonds (NYSEARCA:ILTB) and (NASDAQ:VGLT) could be good performers for another 8 months to a year.

The forecast also implies that the correction/bear market in gold (NYSEARCA:GLD) will continue for 8 months to a year. While I believe the price of gold is in a bubble I have no conviction as to whether the high was in August 2011 or will eventually go much higher.

The inflation implication for stocks (NYSEARCA:SPY) is a bit more complicated. An inflation rate near 2.3% is good for stock valuations about 9 months later. Higher or lower inflation and certainly deflation is less friendly to stock prices. The extraordinary valuations from late 1999 into the late summer of 2000 correspond with inflation being near this optimal level.

(click to enlarge)

The red dots show the data since 1960. In most of this period inflation was above 2.3% so falling inflation generally meant rising stock valuations. However falling valuations in the great recession correspond with inflation falling below the optimal level. This is consistent with the more vintage data.

Nine months ago inflation was 2.9%, fairly close to the level for maximum stock market valuation. I suspect inflation will fall below the level for high stock valuation and then quickly shoot up well past the optimal level. So while inflation is currently friendly to high stock prices it is unlikely to remain so.

(click to enlarge)

The current PEses of 36.9, while well below the turn of the century high, is above 90% of previous valuations. A previous article has information about the PEses I use.

Source: Money Growth Vs. Inflation With Implications For Gold, Bonds And Stocks

Additional disclosure: There is no guarantee analysis of historical data and trends enable accurate forecasts. The data presented is from sources believed to be reliable, but its accuracy cannot be guaranteed. Past performance does not indicate future results. This is not a recommendation to buy or sell specific securities. This is not an offer to manage money.