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Everything You're Told About Inflation Is Wrong

Everything You're Told About Inflation is Wrong by Market Authority

Today, I want to talk about how the money system works and also how it doesn't. Tomorrow, I'm going to share a chart that's making an appearance in Wall Street inboxes that might change the common narrative on inflation.

While the general public may mistakenly believe that inflation is rampant, the common narrative amongst the institutional investment community is that inflation has been tame for several years. Trust me, the risk we face is deflation, not inflation.

There are 2 ways to measure how investors feel about inflation- the price of gold and the interest rate on the US 10 year note. Here are their 5 year charts which demonstrate that inflation has been subdued since the Fed started easing the money supply.

There's a group of investors (let's call them the "inflationistas") who believe inflation has been ruining our economy since the Fed pushed interest rates to zero way back in 2008. The inflationistas are hard-money types, who believe that the $ should be pegged to the price of gold (which Nixon abrogated in 1972). Inflationistas believe that a loose money supply creates inflation which eats up everyone's savings. This is a popular view shared by websites such as shadowstats and zerohedge, and they've been wrong on inflation going on 5 years now.

Here's the inflationista's argument- you start out with $100 in the bank, and a gallon of milk costs $1. So your $100 = 100 gallons of milk.

Next, the Fed adds more money to the system and now there's more $$'s chasing the same quantity of milk, so the price of milk goes up to $2.

So now your original $100 = 50 gallons of milk, reducing your purchasing power by 50%.

(On a side note, I will agree that the price of food has gone up. Food conglomerates have sneaked in price increases by keeping prices the same, but decreasing the amount of food per item. However, these small increases don't represent runaway inflation.)

This simplistic way of looking at the way money works is entirely incorrect. In our monetary system, Quantitative Easing does NOT mean the Fed is "printing" money. Only banks can "print" money by extending more credit. The money in the system is only a "fraction" of the credit extended by banks (about 1/15), providing the name for the fractional reserve system.

In a fractional reserve banking system, banks keep a small amount of cash as reserves and then lend out a magnitude of this amount to worthy borrowers. The system works fantastic for banks and borrowers until depositors attempt to get their money back at the same time (as witnessed in 2008).

So back to how the Fed "prints" money through Quantitative Easing- there's no printing going on at all. The Fed purchases government bonds and mortgages from banks and in exchange gives them more cash, which are held as reserves. The banks can take these reserves and lend them, provided they can find worthy borrowers. The problem in the last few years has been finding "worthy" borrowers, as 50% of Americans found themselves upside down on their mortgage after 2008.

Although the Fed has added $4 trillion in reserves to bank balance sheets, the banks have only lent out a small fraction of this cash. Thus, the cash that everyone thinks is flowing through the system and raising the price of milk is really just sitting on JP Morgan's balance sheet (or maybe in a vault somewhere).

Now, there's a chance this might be changing as the Unemployment rate has dropped significantly in the past 4 years to 6.6% last month and wage growth has been accelerating. Banks are starting to find more worthy borrowers for the mountains of cash they're currently hoarding.

Tomorrow, I'll share the inflation chart making the rounds and discuss the real possibility that the common narrative on inflation is starting to shift.

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