Precious Metals Should Follow Money Supply, Not Monetary Base

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Includes: GLD, SLV, ZSL
by: Pradeep Kandasamy
A lot of arguments have been made that the gains in precious metals are justified due to a massive increase in monetary base in the US from the Fed’s QE policy.
I checked some historical correlation to see how monetary base affects CPI index (inflation). I found that money supply (measured by M2) has a better correlation with inflation. Monetary base did not show any significant relationship.
Below is a chart of CPI Index (US) Vs. USD M2 Money Supply:

The chart below shows CPI Index (USD) Vs. Monetary Base (USD):
Clearly as seen from the charts, M2 is a better indicator of inflation. That makes theoretical sense as well, as deposits with Fed are not going to chase commodities to produce inflation.
The chart below plots M2, monetary base, gold and silver from Oct 2008 (when QE1 started), all normalized from 100:


Red– M2, White – Monetary Base, Yellow – Gold and Green –Silver

Gold has performed in line with expansion in monetary base. Silver has significantly outperformed expansion in monetary base. While monetary base more than doubled from the start of QE1, M2 only increased by 11%. This disconnect between monetary base and money supply indicates contraction of credit and de-leveraging.
Given that M2 is a better indicator of inflation as shown above, the whole basis of this precious metal rally is questionable. Unless M2 increases (credit demand in US picks up again) there might not be any secular inflation worry in US.
Commodity prices by right must follow expansion in M2 rather than monetary base. Accordingly, even gold could be overvalued at current prices. Silver prices don't make sense even if monetary expansion is considered.

Disclosure: I am long ZSL.