Friday, December 12, 2008

The Coming Return Of Inflation

Friday's PPI report for November 2008 again showed a significant price decline, as did Thursday's import- and export price report. Most likely, next week's CPI report will also show a decline in prices (though likely a lot less dramatic). And it also seems likely that when the reports for December are published about a month from now, these price indexes will show another decline.

The most important reason for this was that money supply growth earlier this year had turned first stagnant and then directly negative. That had an immediate impact on the most flexible prices, which is to prices traded in financial markets, including stocks and commodities, although in those cases the global economic downturn had a significant impact as well as it causes corporate earnings and demand for commodities to decline.

Yet we are now likely starting to see the beginning of the end of this brief deflationary period. The reason for this is a reversal of the previous deflationary monetary trends. After reaching a low in the week to October 6, MZM has risen by a full 3.3% in the following 8 weeks, which translates into an annual rate of 23.5%. M2 has risen somewhat less, "only" 2.3%, yet that translates into 16%. And for those who prefer the extremely narrow M1 measure, that is up 5.1%, which translates into an annual rate of 38%. The monetary base is up 49.2% during this 8 week period, which in case you're wondering translates into an annual rate of 1246%. Bernanke hasn't just brought out the helicopters, he has brought out the B-2 bombers too, so to speak.

Because of the extremely high risk aversion, and deteriorating fundamentals for other assets, this massive onslaught of liquidity had at first simply the effect of brining down the effective Fed funds rate (now at just 0.14%, despite the fact that the official target is 1%) and Treasury yields, which at all maturities are trading at all time lows despite the massive increase in the supply of Treasuries due to the dramatic increase in the budget deficit. However, the recovery in stocks and commodities and the decline in the dollar in recent weeks could be a sign that the excess liquidity is spreading from the perceived safe havens to more risky assets, although it must be noted that the weak global economy will probably mean more setbacks for these assets. Still, with Treasury yields so ridiculously low, particularly at the short end (where they as I noted earlier had fallen to zero) certainly creates a climate conducive for alternative assets, despite weak fundamentals. And sooner or later, all the newly created money will spread to other assets and other parts of the economy, and bid up prices of more than just Treasuries.

16 Comments:

Blogger Reginald said...

I define inflation as an increase in the money supply. The money supply consists of US dollars AND bank credit. Bank credit, before the bubble's burst, was ~20x the size of outstanding US dollars. As of today, bank credit is contracting AND overwhelming the creation of US dollars. Thus, the total money supply is still contracting until banks start making loans, which is unlikely in the face of accelerating defaults and unemployment. In the long-term, bank credit will expand on the gigantic amount of newly created US dollars. However, gold will rise in purchasing value because like US dollars it's money and perceived as a safe haven in times of fear.

7:26 PM  
Blogger stefankarlsson said...

Reginald, first of all, bank credit is not the same as money supply, as bank credit is on the asset side of bank balance sheet (and money market transactions) while money supply is on the liabilities side, and since the non-money part of the liability side can change, money supply and credit is not identical. Money supply is money supply, and that is what I showed is increasing at an ever faster rate.

And secondly, as it happens, bank credit is expanding and not contracting (except relative the brief peak in late October that followed a 6% increase in bank credit in 6 weeks).

10:07 PM  
Blogger Reginald said...

stefankarlsson, if any credit is being extended it's due to past agreements on credit lines. Overall, banks are decreasing their lending where they can at an accelerating rate. Take a look at the M1 Multiplier (http://tinyurl.com/5rsmja), which is decreasing, and bank reserves (http://tinyurl.com/66hfzh), which are growing as banks stop lending. In gist, the Fed is printing, but the banks are NOT lending on top of it. Check out Mish (Austrian trader): http://tinyurl.com/65tqev

4:13 AM  
Anonymous Anonymous said...

If you would like to make a profit out of all this excitement, Gold Stocks is the best bet.

Try the ETF called GDX and good luck!

Göran
Sweden

9:23 AM  
Blogger Jeff said...

Would the components of the bank credit numbers have an impact on how the economy plays out? For example if the increase in debt was home mortgages that would obviously be different from credit card debt.

5:02 PM  
Blogger stefankarlsson said...

Reginald, if the Monetary Base grows 50% in 8 weeks and M1 5% in 8 weeks, then that's inflationary and not deflationary. The fall in the M1 multiplier is entrely the effect of an unprecedented increase in the monetary base, and M1 growth is in fact record high. It is of course true that continued deleveraging has a deflationary effect, but what the fast growth in M1 and broader monetary aggregates show is that the inflationary effect of Fed policy right now is stronger.

And Shedlock as usual doesn't know what he is talking about. After having long said that narrow money supply is the indicator of inflation, he has now flip-flopped without any credible explanation. And contrary to what he says, the decline in Treasury yields reflect excess liquidity and is thus an indication of inflation, not deflation.

6:26 PM  
Anonymous Ralph said...

I know this is a late question for this post, but I was traveling and have only just read it.

Do you think it is possible that although the money supply is increasing that the inflationary effect will be muted by the dropping velocity?

3:20 AM  
Blogger stefankarlsson said...

Ralph-it is certainly possible and even likely that the price increasing effect will be limited by decreased velocity, or in other words increased demand for money for non-transaction purposes, as the opportunity cost of holding money falls when interest rates fall.

Even so, if money supply continue to grow as fast as this, this will cause a return of price inflation.

5:16 PM  
Anonymous Anonymous said...

"After having long said that narrow money supply is the indicator of inflation"

Where did Mish write that and which money supply is in question?

Johan

2:15 PM  
Blogger stefankarlsson said...

Johan, see for example here.

9:46 PM  
Blogger Reginald said...

Stefan - "It is of course true that continued deleveraging has a deflationary effect, but what the fast growth in M1 and broader monetary aggregates show is that the inflationary effect of Fed policy right now is stronger."

Hmm. Do you agree that the outstanding bank credit dwarfs the amount of dollars that exist? If yes, it would take a substantial amount of dollar creation by the Fed to overcome the unknown bank credit contraction. I see the money printing, but is it enough? If so, how did you reach that conclusion because the demand for money is subjective and currently rising? Aside: I think we both agree on the long-term negative implications.

10:49 PM  
Blogger Celal Birader said...

Try the ETF called GDX and good luck!

Or you can try DGP which gives you 2x the returns of gold (and 2x the losses if gold goes down).

8:24 AM  
Blogger stefankarlsson said...

Reginald, total credit outstanding is a lot bigger than the money supply, but first of all it is not contracting. Indeed, at least if you include government debt, it is still increasing.

Secondly, credit contraction that don't cause a contraction in the money supply is not deflationary, as it still means that the former creditors hold that money instead of the former borrowers.

And yes, demand for money is rising as a result of the decline in interest rates. But is it really enough to overcome the rapid increase in supply? Possible, but not likely.

9:09 AM  
Blogger Reginald said...

Stefan - "And yes, demand for money is rising as a result of the decline in interest rates. But is it really enough to overcome the rapid increase in supply? Possible, but not likely."

I've read on Bloomberg of negative yields on Treasuries. Oddly, the only sound bank for 'big money' is the US Treasury, and people are willing to pay for safe storage as did most before banks got into fractional reserve lending (e.g. fraud). Isn't that evidence of demand overcoming the Fed's supply? The Fed is an inefficient producer like any government apparatus.

12:10 PM  
Blogger stefankarlsson said...

Reginald, government can sometimes do things efficiently. Or would you stay in a city that was about to be hit with a 10 megaton nuke, dismissing the idea to leave by saying "a government sends that nuke, and government is inefficient"? Just as government can produce 300 million degrees of heat (the heat level in ground zero of a nuclear blast), they can produce 300 million % inflation (Like we've seen in Zimbabwe).

The sharp drop in Treasury bond yields indicate that the increased money supply so far has mostly caused Treasury prices to rise. But the recent drop in the dollar and decline in corporate and mortgage backed bond yields and recovery in most stocks and commodities indicate that some of the increased liquidity is finding its way to other assets.

4:32 PM  
Blogger Reginald said...

Stefan, "...dismissing the idea to leave by saying "a government sends that nuke, and government is inefficient"?

Well, I'd say it was probably an inefficient nuke, but deadly nonetheless.

I'm just amazed how easily the Fed could reflate the system instead of these behind the scenes tricks. Simply seize any of these insolvent national banks, and start making loans to a heartbeat like the bubble last year. Buying mortgages will enrich those who can afford to hold them, but these people will likely just plow the cash back into Treasuries. Maybe that would be too obvious to the average man on the street. It's all wait and see.

4:46 PM  

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