Inflation Held in Check by Fear
History has shown us time and again that out of control money supply expansion creates inflation. In light of the trillions of synthetic dollars that have been injected into the economy by the Federal Reserve over the past five years, most observers (this one included) had expected prices to spiral upward. But in making these determinations, many of us forgot to factor in the supply side of the supply/demand equation. Inflation remains low now because of game changing events that have reduced the demand for money.
As far as the Federal Reserve and the President's Council of Economic Advisors are concerned, inflation is currently holding at around 1.4 percent. However, these authorities choose to focus only on the most generous measurement tools, like the core PCE index. Other common indices, such as the CPI burn much hotter. Current CPI is at 2.9 percent, the highest year-over-year increase since 2008 and more than twice the rate of the core PCE. However, it is widely recognized that even these figures have been manipulated downwards to benefit the Government.
Many more skeptical observers suspect that the real rate of inflation is far north of 6 percent, perhaps closer to 10 percent. But even this figure is far below the rate of expansion that our money supply has undergone over recent years. As of November 17, 2011 the Federal Reserve reported that the U.S. dollar monetary base has increased by 28 percent in just 2 years. Logically we should expect to see a direct correlation between the money supply and the rate of inflation. What explains the breakdown of this relationship?
The dramatic collapse in the real estate market, and the resulting recession and deleveraging, have created a very different dynamic among many consumers, businesses and banks. The fragile economy and lagging global uncertainties have inspired dramatic removal of risk, thereby slowing the circulation of money. The dimming of animal spirits should act as a weight on the general price structure. Put simply, a recession should push prices down.
The savings, retirement accounts, and real assets of consumers suffered massively in the recession of 2008/9. Cash flow shortages drove many companies into liquidation. Banks that had speculated in real estate or had made irresponsible so-called covenant-light loans had to be rescued by the taxpayer or by other more conservative banks. Therefore, corporations and banks joined consumers in becoming far more conservative. Indeed, although banks are stuffed full of deposits, bank finance remains extremely tight.
Before the crash, many consumers and corporations had grown accustomed to the continual growth of asset prices. Therefore they grew comfortable with leverage as a means to safely increase wealth. Even banks shared this sanguine view.
Today, consumers have become conservative, spending mostly on what they see as essentials. Corporations have adjusted, cut costs dramatically and have accumulated an aggregate of some $2 trillion in cash. The Fed now pays banks interest on excess reserve deposits and charges near zero percent for loans. In response, banks prefer to lend to the Fed or government, via Treasury bonds, than to lend to ordinary customers, which, under new regulations, requires more capital reserves. Who can blame them?
When the Fed injects money into its distribution system of banks, the money becomes part of the monetary base. It is only when these banks lend the money that it becomes part of the money supply. If the demand for money is muted, inflation will remain muted no matter how much money is made available as monetary base. Indeed, this is the reason that the stimulus packages have enjoyed so little success in terms of increasing consumer demand and jobs.
Therefore, in the absence of demand from consumers and corporations, massive monetary injections of synthetic Fed money have little effect on inflation. The key question remains as to how long the dramatic change in consumer attitude will last and keep inflation subdued?
The price of gold is revealing on this point. A very different dynamic exists in the market for gold than does in the market for electronics, furniture or stocks. Gold buyers by nature are extremely sensitive to monetary policy, and tend to look to gold when central bankers lose credibility. The gold market is also wholly international and is driven more by the growth in the emerging markets rather than the stagnation in the developed world. As a result, the dollar price of gold has been much more correlated over the long term with the increase in U.S. money supply.
So beware of the recovery. Any wakening of animal spirits in the U.S. will likely stir the dormant threat of inflation, which if it were to reveal itself in force, may very well short-circuit the recovery itself. This is a riddle that may be impossible for Mr. Bernanke to decipher.
John Browne is a Senior Economic Consultant to Euro Pacific Capital. Opinions expressed are those of the writer, and may or may not reflect those held by Euro Pacific Capital, or its CEO, Peter Schiff.
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