The Inflation-Deflation Debate
Feb 3, 2009
Below is an excerpt from
a commentary originally posted at www.speculative-investor.com
on 1st February, 2009.
Confusion due to delays
For many years we have been
expecting inflation (growth in the supply of money) and nothing
but inflation as far as the eye can see, but there have been
times, such as the past 12 months, when we have felt more affinity
with deflation forecasters than with most other inflation forecasters.
The reason is that monetary inflation, when measured correctly,
was minimal during the first half of 2008 and during the two
preceding years, thus setting the stage for a US$ rebound and
large price declines in the investments that had been bid up
to astronomical heights.
Based on our observation, a lot of confusion on the inflation/deflation
issue is caused by the lengthy and variable time delays between
changes in the monetary trend and changes in prices. It will
often be at least 2 years before the effects of a major change
in the monetary trend start to become apparent in the prices
of commodities and everyday goods and services. Consequently,
during the first 2 years of a new monetary inflation cycle the
outward evidence will often point to deflation (even though the
inflation threat is rising), and for 2 years following the END
of an inflation cycle it will seem as if the inflation threat
is growing (even though it is falling).
As outlined below under "Current Situation", a new
inflation cycle has almost certainly begun. However, with one
notable exception the price-related evidence will probably favour
the deflationists until at least 2010. The notable exception
is the gold price. As we mentioned in a few commentaries last
year, the gold price is the one price that's likely to commence
a major upward trend in the early part of a new inflation cycle.
The reason is that the gold market is dominated by large speculators
who take positions in anticipation of the eventual/inevitable
effects of the new monetary trend.
To further explain, the gold market is a very different 'kettle
of fish' to other commodity markets. In the gold market the "commercials"
are generally clueless because garden-variety commodity supply/demand
fundamentals, such as changes in mine supply and industrial/commercial
demand, have almost no effect on gold's price trend. Instead,
gold's price trend is determined almost totally by investment
demand, which is, in turn, driven by the outlook for things such
as interest rates, credit spreads, financial asset valuations,
money-supply growth, inflation expectations, and exchange rates.
Moreover, the people who tend to have the most foresight when
it comes to macro-economic phenomena are speculators who have
survived and prospered in the financial markets over a long period
In sum, even though the inflation threat has begun to increase
the deflationists will probably look right for at least another
year. They rarely look right, so we shouldn't begrudge them their
relatively brief time in the sun.
We agree with much of the analysis
presented by the well-known deflationists. The main point of
contention revolves around the ability of the monetary authorities
(the Fed and the Treasury in the US) to keep the total supply
of money growing. Our view has been, and continues to be, that
the Treasury-Fed tag team has the power to promulgate monetary
inflation under almost any economic circumstances and will use
this power. The bond market could eventually impose a practical
limitation on the government's ability to inflate because increasing
the money supply becomes counter-productive once the bond market
begins to anticipate rapid currency depreciation, but if price-related
evidence continues to favour the deflation view over the coming
year then this limitation will not arise anytime soon.
The case is not yet closed, but the evidence presented to date
supports our view. For example, the monetary base has expanded
at an astronomical pace over the past five months. Mike Shedlock
has attempted to counter this by pointing out that a sharp increase
in the adjusted monetary base (AMB) also occurred during the
early 1930s, but the St. Louis Fed's updated long-term
chart of the AMB shows that the recent increase has been
many times greater than anything during the 1930s. In any case,
the overall monetary situation today could hardly be more different
to the early 1930s. During the early 1930s the Fed increased
the monetary base, but the total supply of money plunged. The
current situation is reflected on the following chart, which
shows that the year-over-year rate of increase in the True Money
Supply (TMS) has reached 10%. Note that TMS does not include
bank reserves held at the Fed; it represents money available
for spending. The fact is that despite the deflation hysteria
there is 10% more money in the US economy today than there was
at this time last year.
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