Certainty Vs. Uncertainty In Quantitative Easing, The Money Supply, And Inflation

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Includes: AA, BTU, VALE
by: Ted Waller

Summary

Since 2008 we have learned two important things about the relationship of money supply and inflation.

An elevated money supply is now and always will be an inflation risk.

In a market with stocks at or near record prices certain commodity companies may provide opportunity for the fearless investor.

The Great Debate

One of the great debates revived by quantitative easing in 2008 was whether or not increasing the money supply would cause inflation. Today, almost six years later, it looks like the debate is over. Or is it? The answer depends on the question you ask.

There are two main questions of interest:

  1. Will an increase in the money supply cause an increase in inflation?
  2. Do changes in the money supply have a relationship with inflation?

The first question is answerable with certainty, the second question is not. Both answers are found in the well-known equation of exchange, formulated by Irving Fisher in 1911:

M * V = P * Q

Where M is the supply of money, V is money velocity, P is the price level (inflation/deflation), and Q is quantity of goods sold (economic growth).

It is important to understand that this is not an equation, it is an identity, something true by definition (for readability both terms will be used interchangeably here). It is also referred to as a tautology, something which is true in every possible interpretation. In this identity there is a direct (as opposed to inverse) relationship between an increase in M and an increase in P or Q. After the initial crisis in 2008, this was the principal foundation for the Fed's $3.2 trillion quantitative easing program. The explicit goal was to increase inflation and growth by increasing the money supply. To the consternation of many, including the august Fed governors, what happened instead was a stunning drop in V, the velocity of money. Although this result was unexpected, it conclusively answers both Question 1 and Question 2. It clearly demonstrates that increasing the money supply does not necessarily lead to inflation. However, by reaffirming the equation of exchange it validates the direct relationship between money supply and inflation.

What About the Future?

The confirmation of Question 2 has important implications for the future. Going forward, M is at a permanently higher level than before the Great Recession. There are serious risks to all approaches to reducing the Fed's balance sheet, and there are no plans at present for the Fed to do anything more than keep its assets at the current level. The most benign approach, letting securities run off the balance sheet as they mature, would take many years to complete. Ongoing discussions at the highest levels show both a recognition of the problem and the difficulty of doing anything about it. The critical fact is this:

The potential for the higher money supply to cause inflation is still present and will remain as long as the the money added by the Federal Reserve is there.

The money is there, the identity is valid, and future changes in the other three variables will have to account for the added weight on the left side of the equation. To be clear, this is not an inflation prediction. It is an acknowledgement of the relationship between money supply, prices, and growth.

Investment Implications

Each individual must decide for themselves how much of a role a permanently higher M will play in their investment decisions. For those who believe there is a future inflation risk there are specific implications. One category of companies positioned to benefit from such a scenario is those that own assets with intrinsic value, i.e., commodities. The link between commodity prices and inflation is well recognized. See these 3 sources for some useful discussion of the topic: Morningstar, NBER, Pimco. Although it's difficult to find bargains in equities today, commodity companies are an exception. The prices for many commodities are low, and the direct relationship between company profits and their underlying commodity prices may present timely investment opportunities.

Three commodities at relatively low prices are coal, iron, and aluminum. The following chart shows ten year nominal prices in dollars per metric ton:

 

High- Low 2004-2014

Recent

Coal

180-38

69

Iron

197-60

92

Aluminum

3070-1330

2030

Source: World Data Bank Global Economic Monitor

As coal prices flirt with the cost of production, low cost producers like Peabody Energy (NYSE:BTU) will be best positioned to survive. At multi-year lows, it may present an excellent buying opportunity:

Peabody Energy

2004-2014 price range: 84.05-12.65
Price 9/26/14: 12.08

Source: Yahoo Finance

In the iron sector, industry giant Vale S.A. (NYSE:VALE) is a low cost producer approaching multi-year lows:

Vale, S.A.

2004-2014 price range: 43.91-9.67
Price 9/26/14: 11.19

Source: Yahoo Finance

Alcoa (NYSE:AA), perhaps getting ahead of itself, is well off its lows. In terms of aluminum prices and historical share prices it could still be worthy of consideration.

Alcoa

10 year price range: 47.35-5.22
Price 9/26/14: $16.19

Source: Yahoo Finance

The factors that determine a stock price are many, and the challenges facing companies like Peabody, Vale, and Alcoa are well known. A certain contrarian fearlessness is required, as these companies quickly bring to mind the saying, "Be greedy when others are fearful." However, the pricing environment these companies are experiencing is a major reason for their difficulties, and when pricing eventually improves it will be reflected in their stock price.

Summing Up

It may seem pointless or even foolhardy to be discussing inflation in today's environment, where most economic forecasts suggest the possibility is remote at best. However, the equation of exchange reminds us that our higher money supply makes the probability higher than it would be otherwise. The investor who incorporates this into his or her decision-making will want to look at commodity companies, particularly those whose underlying assets are at a low point in the price cycle.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

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