The Money Cycle, Stock Market, And The Return Of The Inflation Premium - This Chart Is Off The Scale

by: Atle Willems


With bank credit growth contracting, this money cycle is slowly but surely approaching the end.

This could soon spark calls for the Federal Reserve to intervene, though it likely would react to late to stave off a stock market crash.

Whether the Fed intervenes or not, the risk of price inflation picking up is significant as monetary inflation has outpaced price inflation on an unprecedented scale in recent years.

A chart showing the ratio between the money supply and price inflation suggests the inflation component of interest rates could soon return with a vengeance.

Let it first be clear that there can never be "too much" or "too little" money in an economy; any amount will do as long as money is divisible. Since money is simply a medium of exchange, there can only be prices that are too low or too high instead. We therefore have,

"Too much" money = Prices are too low
"Too little" money = Prices are too high

In times of financial crisis, governments and central banks will swiftly call for an additional injection of money as a remedy for falling (asset) prices. They however fail to see, or don't want to see (for whatever reason), that more money and hence more debt is not the solution to already too much debt, bad investments and mounting defaults, especially as they were made possible in the first place through the money creating abilities of the banking system which the government and the Federal Reserve are in fact in charge of.

All "developed" economies today operate under a fractional reserve banking system. Under such a banking system depository institutions ("banks") and central banks have the ability to create new money. Banks create new money in two main ways: 1) issuing new loans and 2) buying securities from the non-bank public. The two make up what is referred to as bank credit. Central banks on the other hand can create new money either directly through buying debt from the non-bank public including the government ("monetizing" government debt) or indirectly through buying securities from banks. The latter increases the amount of bank reserves which makes it possible for banks to expand lending or buy more securities. Conversely, by doing the opposite, banks and central banks are able to reduce the amount of money in an economy. The quantity of money (the money supply) in an economy can hence be referred to as elastic as it can both expand and contract rather effortlessly and with few direct costs.

The money supply's ability to change is the primary cause of the artificial booms and very real economic busts that have become only too common around the fractional reserve banking world. Broadly speaking, artificial booms are fuelled by increases in the money supply growth rate while contractions in this growth rate trigger the inevitable real busts. In "normal" times, banks are the primary drivers of changes in the money supply and its customary expansion over time. As Murray Rothbard once succinctly put it when discussing in part the "Austrian" business cycle theory (ABCT),

Without bank credit expansion, supply and demand tend to be equilibrated through the free price system, and no cumulative booms or busts can then develop. But then government through its central bank stimulates bank credit expansion by expanding central bank liabilities and therefore the cash reserves of all the nation's commercial banks. The banks then proceed to expand credit and hence the nation's money supply in the form of check deposits. As the Ricardians saw; this expansion of bank money drives up the prices of goods and hence causes inflation. But, Mises showed, it does something else, and something even more sinister. Bank credit expansion, by pouring new loan funds into the business world, artificially lowers the rate of interest in the economy below its free market level.

It is this artificial lowering of interest rates that creates the business cycle and the accompanying stock market booms and busts.

Following the massive monetary injections by the Federal Reserve during the 2008 to 2014 period, it is the banks that once again have been "in charge" of creating additional credit and with it money. It now appears however that a trend of declining credit growth has become the norm.

If this continues, economic reactions will be triggered and stocks could fall sharply. With declining credit growth, chances are the Fed will step in with QE4 at some stage to sort out an alleged "scarcity of money problem" (read: prices that are too high and which must come down for the market to clear).

Chances are also however that the Fed will arrive too late, if it arrives at all, to stave off a stock market sell-off. Why? Firstly, based on the past, the Fed regularly fails to see the economic and financial instability it itself creates with its inflationary policies. Secondly, the Fed will likely need a crisis before it is actually able to intervene further, not least due the potential political challenges of implementing QE this time around after the uproar it created last time around. Also, with bank excesses reserves still north of $2 trillion, why would, or should, the Fed buy securities from or extend loans to banks at all? This is of course one reason the concept of "helicopter money" has been put out there in the open. Thirdly, QE4 might take away the remaining confidence market participants have in central bank intervention. This could inflict damage on the confidence in the US dollar with a range of repercussions following in its wake, including the potential for significant increases in the inflation component of interest rates. Again according to Rothbard (emphasis added),

And this is precisely what happens in the first decade or two of chronic inflation. Fed expansion lowers interest rates; Fed tightening raises them. But after this period, the public and the market begin to catch on to what is happening. They begin to realize that inflation is chronic because of the systemic expansion of the money supply. When they realize this fact of life, they will also realize that inflation wipes out the creditor for the benefit of the debtor. Thus, if someone grants a loan at 5% for one year, and there is 7% inflation for that year, the creditor loses, not gains. He loses 2%, since he gets paid back in dollars that are now worth 7% less in purchasing power. Correspondingly, the debtor gains by inflation. As creditors begin to catch on, they place an inflation premium on the interest rate, and debtors will be willing to pay. Hence, in the long-run anything which fuels the expectations of inflation will raise inflation premiums on interest rates; and anything which dampens those expectations will lower those premiums.

Since the eve of the banking crisis in September 2008, growth in the money supply (True Money Supply) has outpaced price inflation (PCE Price Index) on an unprecedented scale, certainly based on the past 25 years or so. As the chart below shows, the ratio between the money supply and price inflation (both indexed to December 2007) today stands at a record 75x while it averaged only around 4x for the 17 year period ending in August 2008. This is potentially more significant than most of us can even imagine.

Other than falls in the level of production of goods and services, it is increases in the money supply that drives price inflation. As production clearly hasn't kept pace with the money supply in recent years (the money supply has more than doubled since August 2008), it seems to me it is only a matter of time before price inflation picks up substantially (or the PCE numbers are revised up). The inflation component of interest rates will then increase, perhaps on a scale even surpassing that of the late 1970s and early 1980s.

It also seems to me that the U.S. economy is slowly but surely approaching the end of yet another money cycle as the longer term growth rate in the money supply has been falling steadily for some time.

If that is the case, this does not bode well for future stock market returns either, especially as valuations are at or near record highs based on a range of fundamentals (e.g. here and here).

The end game for any economy following several round trips (upswings and downswings) in the money cycle roundabout is either increasing poverty or the end of the existing monetary system. In any case, economic prosperity will fall short of potential. How many round trips (see chart below) are required for the end game to arrive and whether it ends with widespread poverty or the end of the monetary system depend in part on the length and extent of each inflationary boom, in part on the degree to which businesses are still able to maintain and increase production, and in part to the extent the economy at large manages to accumulate sufficient amounts of savings despite the monetary headwinds. In the meantime, thread carefully and actively seek protection from inflation.

Source: Money Cycles - The Curse of an Elastic Money Supply

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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