A Strange Inverse Relationship

By: Steve Saville | Tue, Sep 12, 2006
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Below is an extract from a commentary originally posted at www.speculative-investor.com on 7th September 2006.

During much of the period between August of 2001 and July of 2003 one of the major concerns in the financial world was that deflation had become a legitimate threat. In fact, the fear of deflation became so pronounced during 2002 that Greenspan felt the need to wheel-out Ben Bernanke to discuss, in very blunt terms, the Fed's ability to devalue the currency by creating unlimited amounts of the stuff. Furthermore, the Fed, which has often attempted to paint itself as an inflation-fighter, began publicly worrying about an unwelcome FALL in inflation. Interestingly, however, and as reflected by the following chart of year-over-year M2 growth, the TROUGH in inflation fears coincided with the PEAK in actual inflation (money supply growth).

Around the middle of 2003 the fear of deflation quickly began to evaporate and prices began to rise. In fact, there was such a turnaround in sentiment that by the second quarter of 2004 inflation was once again viewed to be 'public enemy number one'. Sentiment had done a 180-degree turn due to surges in the prices of commodities, equities and houses, as well as signs that the labour market was becoming quite strong. However, with reference again to the following M2 chart notice that the re-emergence of the inflation bogey in the minds of market participants occurred after actual inflation had fallen to a relatively low level.

The inverse correlation between actual inflation and fear of inflation that's been evident over the past several years is not as strange as it might appear to be at first glance. It arises due to four main reasons: First, because there is usually a substantial time delay between the cause (growth in the money supply, a.k.a. inflation) and the effect (an increase in prices). Second, because the effects of inflation are almost always non-uniform (different prices are affected in different ways at different times). Third, because most people have been conditioned to view rising prices as the problem rather than as an effect of the problem. And fourth, because the Fed and all other modern central banks react to what's happening with prices (they frame their monetary policies in response to the lagged effects of the inflation rather than to the inflation itself)*.

So, what we end up getting is the following cycle:

1. In response to weak economic growth or some other perceived crisis, the central bank takes actions designed to cause inflation (designed, that is, to stimulate growth in the money supply). At this point inflation fears are low, but there is little fear of deflation.

2. The supply of money begins to grow rapidly in response to the central bank's inflationary policies, but as a result of falling economic growth and plunging asset prices the main fear is that the bank's efforts to elevate prices will come to no avail. The word "deflation" starts making regular appearances in the financial news media. Reporters working for the mainstream financial press seek-out the views of perennial deflation forecasters who are ready with their explanations for why the current surge in the money supply will inevitably be overwhelmed by the deflationary tide. Catchphrases such as "pushing on a string" are widely used to describe the futility of the Fed's inflationary efforts.

3. A large increase in the supply of money will ALWAYS lead to higher prices somewhere in the economy, so after a (sometimes substantial) time delay prices begin to rise in response to the central bank's actions. However, by this stage in the process the actual inflation rate (the money-supply growth rate) is well past its peak.

4. As time goes by the effects of the preceding inflation continue to bubble-up to the surface and eventually become apparent in the popular price indices. The debt market begins to discount more currency weakness (the market pushes bond yields upward) and central bankers, worried that inflation fears could soon get out of hand, decide to tighten monetary policy. By this stage in the process, however, market forces have caused the actual rate of inflation to fall to a relatively low level, paving the way for a future REDUCTION in the rate of currency depreciation.

5. After a period of monetary tightening the central bank and the markets begin to fear that the risk posed by a weakening economy has become greater than the risk posed by currency depreciation (one of the main effects of inflation). That is, the fear of slower growth gains the ascendancy. The central bank's tightening campaign thus comes to an end, but by this time a severe economic downturn is 'baked in the cake'.

6. In response to weakening economic growth and/or a crisis brought about by the unwinding of the preceding central-bank-created inflationary boom, the central bank begins implementing policies specifically designed to cause more inflation.

In a world where counter-cyclical monetary policy dominates and where "Keynesian economists" are well respected, more inflation will always be the prescribed remedy for the problems caused by inflation. This is partly because so few people recognise the underlying cause of the problem and partly because many of the ones who do perceive the true cause think that it's better to implement a 'bandaid solution' that allows the game to continue for a while than to implement a long-term fix.

At the current time the financial world appears to have just entered Stage 5 in the above cycle, although things are precariously balanced. In particular, if the gold price were to break above its May high over the next 2 months -- not something we expect but certainly not something we can rule out -- then the markets and the Fed would likely shift back to Stage 4 (the Fed would resume its rate-hiking to prevent inflation fears from getting out of hand).

*Central bankers don't operate in this way out of stupidity. They are well aware of the consequences of inflation, but their charter is not to stop the inflation in its tracks. Rather, their charter is to keep the inflation going whilst managing inflation expectations; and inflation expectations generally only rise to worrisome levels after the prices of commodities, goods and services have moved considerably higher in response to the inflation facilitated by the central bank.

 


 

Steve Saville

Author: Steve Saville

Steve Saville
speculative-investor.com
Hong Kong

Steve Saville

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