Fed’s Serious Inflation Risks

Adam Hamilton     October 2, 2015     3062 Words

 

Traders today universally believe inflation is dead, that there is no persistent decline in the purchasing power of money.  That’s what government price indexes around the world are indicating.  But this false notion is one of recent years’ main Fed-conjured illusions.  Price inflation is the result of rising money supplies, and they have been skyrocketing.  Serious risks are mounting that they will spill into price levels.

 

As simple as money seems, it is very complex in both theory and practice.  We all understand the idea of working to earn money to buy goods and services.  But the seminal treatise on money, the legendary economist Ludwig von Mises’ “The Theory of Money and Credit” published in 1912, weighed in at 445 pages!  Money is a topic that endlessly preoccupies elite central bankers with doctorates in economics.

 

Money is ultimately a commodity, its value determined by its own fundamental supply and demand.  If demand exceeds supply for any given currency, its price will rise relative to other currencies.  As this money grows more valuable, it takes relatively less to buy goods and services.  The persistent increase in the purchasing power of money, resulting in a persistent decrease in general price levels, is deflation.

 

Today systemic deflation is assumed and feared by traders around the world.  They look at the various price indexes published by governments, which show either slowing increases in general price levels or slight decreases.  They worry incessantly that the former disinflation will decay into the latter deflation.  So the idea that there are big risks of serious inflation breaking out is hyper-contrarian heresy, widely ridiculed.

 

Yet think about the commodity of money.  Deflation requires demand growth to exceed supply growth, which is clearly not happening.  In this era of extreme central-bank easing globally, money supplies all over the world are literally skyrocketing!  With supply growth radically outpacing demand growth, the only possible ultimate outcome has to be big inflation.  There is always a reckoning for huge monetary expansion.

 

Central banks have been conjuring vast amounts of new money out of thin air to buy bonds, the blatant debt monetization now pleasantly euphemized as “quantitative easing”.  The resulting exploding money supplies guarantee each unit of currency is going to be worth less.  With the money supplies growing far faster than the real-world pool of goods and services on which to spend it, serious inflation is inevitable.

 

Inflation is the persistent increase in general price levels driven by the persistent decline in money’s purchasing power.  And given the extreme, wildly-unprecedented, and record levels of money printing the US Federal Reserve has executed in recent years, Americans are facing a major inflationary episode in the coming years.  Excessive central-bank money printing throughout history always leads to serious inflation.

 

The Fed started sowing the seeds for this coming inflation back in late 2008.  That year the US stock markets suffered their first full-blown panic in a century.  In just 21 trading days leading into late October 2008, the flagship S&P 500 stock index plummeted 30.0%!  The first two weeks of this alone witnessed an astounding 25.9% free fall, handily exceeding the formal stock-panic metric of a 20% drop in 2 weeks.

 

The US Federal Reserve was founded in late 1913, largely in response to the last true panic seen in US stock markets in 1907.  So this central bank had never weathered a stock panic before, and its central bankers were utterly terrified.  They feared we were on the verge of a new Great Depression due to the wealth effect.  When Americans’ perceived wealth declines due to market selloffs, their spending falls in sympathy.

 

For all their power, central banks really only have two tools available.  The great newsletter writer Franklin Sanders describes them as “liquidity and blarney”.  Central banks can either print money, or talk about printing money.  And with the Fed literally panicking in late 2008, it spun up the printing presses with a vengeance.  This is readily apparent in this first chart of the narrowest US money supply.

 

This is called the monetary base, or M0 (M-zero).  While the definitions of the various money-supply measures vary in different countries, the monetary base includes money in circulation, money in bank vaults, and reserves banks hold with the Fed.  Here’s the US monetary base and its annual growth rate charted over the past third-of-a-century or so.  Note the radical disconnect seen during late 2008’s stock panic.

 

 

That event that forever changed global markets thanks to central banks’ extreme reactions started in September 2008.  During the 28.7 years before that beginning in 1980, the average annual growth rate in the monetary base ran 6.2%.  That’s the baseline for normal monetary conditions.  But in late 2008 when the Fed joined stock traders in panicking, it ramped its money printing up to stupendously-extreme levels.

 

The Fed rushed to inject liquidity into the system, creating vast torrents of new money out of thin air to try to stave off the feared depression.  In just 4 months leading into December 2008 centered on that epic stock panic, the Fed had catapulted its monetary base 101% higher!  It peaked at a staggering annual growth rate near 117% in May 2009.  The money supply was exploding, a wildly-unprecedented event.

 

While these epic panic expansion rates didn’t last, the Fed never unwound its extreme money creation!  Instead it followed its initial QE1 bond-monetization campaign with QE2 and QE3 in subsequent years, each of which greatly boosted the monetary base.  When central banks buy bonds, they don’t use money that already exists.  Instead new money is literally created out of thin air with the stroke of a keyboard.

 

So thanks to the Fed’s enormous quantitative easing of the post-stock-panic era, the monetary base has exploded from $847b in August 2008 to $4099b today!  That extreme 4.8x increase was fueled by an incredible average annual M0 growth rate of 27.8% in the 7.1 years since the stock panic.  The critical question traders need to ask is whether such record money creation can magically have no inflationary consequences.

 

Price inflation is the result of money supplies growing faster than the underlying pool of goods and services in the real economy on which to spend it.  And there is absolutely no way the US economy today is roughly 5x larger than it was in late 2008, like the monetary base.  That means there is a giant overhang of excess money out there threatening to flood into the real economy and drive up price levels.

 

The Fed intentionally injected this epic monetary inflation into the system.  It wanted to artificially lower interest rates to boost economic activity, to stop the stock panic’s wealth effect from cratering the US economy.  So it bought trillions of dollars of bonds.  The Fed monetizations of US Treasuries enabled the massive government overspending of the Obama years, “financing” that Administration’s record deficits.

 

This vast monetary inflation indirectly led to the extraordinary post-panic stock-market levitation.  The extremely-low interest rates created by the Fed’s enormous bond buying led US corporations to borrow way over a trillion dollars to buy back their own stocks.  Instead of growing their businesses, companies took advantage of the gross Fed distortions to manipulate their earnings per share higher through vast buybacks.

 

There is zero doubt the Fed’s extreme money-supply expansion of recent years led to great inflation in bond and stock prices.  With relatively far more money chasing relatively far less investments, their price levels were bid dramatically higher.  The colossal inflation of asset prices by the Fed and other major central banks is undisputed.  Markets would look far different today if the Fed hadn’t quintupled its monetary base!

 

It’s ironic how traders today fully understand how bond and stock prices would be far lower without the Fed’s extreme money printing, yet deny the threat of inflation.  Once central banks unleash new money, they are powerless to control where it flows.  Eventually money-supply expansions always permeate into general price levels.  And despite what the government price indexes claim, this is already happening.

 

When the Fed conjures new dollars out of thin air to buy US Treasuries, what does the government do with this new money?  Rapidly spends it.  The money the Fed used to buy those government bonds immediately goes to Americans in the form of redistribution transfer payments, direct government salaries, and government purchases of private-sector goods and services which indirectly pay countless others.

 

This brand-new government money is then soon spent by its ultimate recipients on their own goods and services, bidding up general price levels.  All that money the Fed has printed hasn’t just magically stayed in the bond markets segregated from the real economy, it was already injected right in almost as soon as it was wished into existence.  Traders who buy into the deflation myth simply don’t understand money.

 

Much if not most of the Fed’s incredible $3.3t monetary-base expansion since late 2008 is already out there in the real US economy.  This is a ticking time bomb threatening money-supply-growth-fueled widespread general inflation.  And contrary to government-price-index claims of persistent disinflation or deflation, this serious inflation the Fed has unleashed is already becoming apparent to the observant.

 

Think of your and your family’s own financial situation, your personal economy.  Has your cost of living been rising or falling in recent years?  Are you having to pay more for virtually everything you need and want to live?  Are your tax costs, housing costs, education costs, medical costs, utility costs, food costs, and entertainment costs rising or falling?  Everyone I talk with is already seeing sharp real-world inflation.

 

Pretty much everything we buy on an ongoing basis is getting more expensive.  With vastly more dollars in circulation in recent years thanks to extreme Fed money printing, the purchasing power of each has declined considerably if not dramatically.  While there are certainly exceptions, most Americans are all too painfully aware that general price levels are relentlessly rising.  Maintaining lifestyles requires more money.

 

The price indexes published by governments around the world are woefully inadequate for measuring prevailing price levels.  Prices are just inherently difficult to measure.  Our consumption patterns are constantly changing, with endless substitutions as prices and tastes evolve.  Any basket of goods and services used to measure prices is soon obsolete, with a constant measuring rod impossible to achieve.

 

And governments actively obscure general-price-level increases as well for political reasons, muddying the picture.  Higher reported inflation is bad for politicians’ job security.  It leads to lower stock-market levels and thus greater electorate dissatisfaction.  Provocatively, stock-market changes leading into US presidential elections are one of the most powerful predictors of their outcome!  Incumbents lose when stocks weaken.

 

Higher reported inflation levels also cost governments big money in transfer payments, many of which are linked to their own government’s inflation gauge.  The more governments have to raise things like welfare and pension payments to keep pace with reported inflation, the less money politicians have to spend on things that can win them votes.  So governments have vast incentives to lowball reported inflation.

 

And they do.  The US’s definitive inflation gauge that traders swear by is the Consumer Price Index published monthly by the Labor Department.  It is showing zero inflation right now, a stark contrast to the actual experiences of Americans!  This next chart shows the broad MZM (money of zero maturity) money supply, overlaid by its own annual growth rate and that of the CPI.  Their great disconnect remains glaring.

 

 

Not surprisingly with the monetary base soaring thanks to the Fed’s extreme debt monetizations of recent years, the broad MZM money supply has surged massively as well.  Since August 2008, MZM has exploded $4.9t higher!  While this is in line with M0’s $3.3t growth, it is much smaller in percentage terms at a 56% gain compared to 384% because MZM was larger to start with.  But this is certainly an anomaly.

 

The narrow monetary base directly supports the broad MZM money supply.  Between 1981 and August 2008 when M0 averaged $450b, MZM averaged $3615b.  This rough comparison suggests each dollar of monetary base supports about 8 dollars of broad money supply.  In one of fiat money’s complicating factors, the monetary base is multiplied into a larger money supply by the fractional-reserve banking system.

 

When money is deposited in banks, the banks are allowed to lend out much more than deposited.  They only need to keep reserves for a small fraction of their deposits, multiplying the money supply.  Eventually as the Fed’s vast recent monetary-base expansion is absorbed, it has the potential to support a colossal MZM of $32.9t!  That’s a staggering 2.4x above today’s levels.  That would unleash an inflation superstorm.

 

But back to today’s reported-inflation situation, the US government’s CPI is claiming no inflation right now despite MZM still surging over 7% per year.  Since expanding money supplies drive increases in general price levels, and MZM continues to grow rapidly, how on earth can there be zero inflation in the US today?  It doesn’t make any sense that a fast-ramping money supply isn’t driving purchasing-power losses.

 

But this disconnect is a temporary anomaly, not some new era where prices are somehow divorced from the money supplies which determine them.  The government reporting that inflation doesn’t exist sure doesn’t mean it doesn’t exist.  And more and more Americans are waking up to this, unable to reconcile Wall Street’s price-index-fueled deflation worries with their own personal experiences of endlessly-rising prices.

 

Traders have duped themselves into believing that the most extreme central-bank money printing in world history will have no inflationary consequences, a ridiculous notion.  They think that these trillions of dollars of newly-created money can be magically fenced into the bond and stock markets, where they love to see price inflation.  They believe mushrooming money supplies won’t spill into the underlying real economy.

 

But history has proven over and over that big central-bank money printing always leads to big real-world inflation.  There can be no other possible outcome as relatively more money chases relatively less goods and services, bidding up their prices.  The faster the supply of anything grows, the less each unit of the existing supply is worth.  Money has never been an exception to these ironclad laws of supply and demand.

 

There will absolutely be a reckoning for the Fed’s extreme post-panic money printing, serious adverse consequences for prevailing price levels.  The Fed either has to fully normalize its balance sheet to where it would have been without the epic debt monetizations, or serious inflation is inevitable sooner or later here.  And the Fed will never muster the courage to materially unwind its incredible bond purchases.

 

If the Fed had not panicked in late 2008 and kept the monetary base on its normal trajectory, it would be down around $1.1t today.  So a full normalization would require an astounding $3.0t of bond selling by the Fed!  When central banks sell bonds that they created money to buy, that new money vanishes back into oblivion.  So if the Fed sold $3t in bonds, even over many years, it would unleash a market apocalypse.

 

Bond prices would collapse, sending interest rates soaring.  That would utterly devastate much of the real economy reliant on debt financing, led by housing.  Stock markets would fall for years on end as both higher-yielding bonds sucked capital away and higher borrowing costs weighed on corporate profits and sales.  The Fed has painted itself so far into a corner that it can never fully normalize its vast monetizations.

 

And that means the only possible outcome is the near-quintupling of the US monetary base in 7 years is going to lead to serious general price inflation in the years to come.  That’s the way monetary expansion has always worked historically, even though this process takes some time to fully run its course.  And investors and speculators alike today wrongly fearing the deflation boogeyman are woefully unprepared for inflation.

 

History’s strongest asset in inflationary times, which are always unleashed by excessive central-bank money printing, is gold of course.  Gold thrives when currency values are falling thanks to rapidly-growing money supplies.  Investors start shunning cash as its purchasing power drops, and park capital in gold to preserve their purchasing power.  This rising investment demand leads to surging gold prices.

 

And with gold so deeply out of favor in recent years thanks to the Fed’s extraordinary QE-fueled stock-market levitation, investors remain radically underinvested in gold.  This gives gold enormous upside as deflation worries eventually yield to the real threat of serious inflation the Fed has unleashed.  Gold and its leading ETF, the GLD SPDR Gold Shares, will thrive as prudent portfolio diversification returns to favor.

 

But the greatest gains in the gold sector by far in inflationary times will come from the left-for-dead stocks of its miners.  Despite gold miners’ low costs and recent fundamentally-absurd price levels, traders have abandoned them on the historically-false belief that Fed rate hikes are terrible for gold.  So as gold mean reverts higher in the coming years, its gains will be dwarfed by the uplegs in the best of the gold stocks.

 

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The bottom line is the Federal Reserve has nearly quintupled the monetary base in just 7 years since 2008’s stock panic.  This extreme money printing can’t be unwound without collapsing the bond and stock markets and causing interest rates to skyrocket, something the Fed will never risk.  So it has no choice but to let the money supply remain near its vastly-inflated levels today, a harbinger of serious price inflation.

 

Such vast amounts of new money really lower the purchasing power of existing money.  With relatively more money chasing relatively fewer goods and services, higher general price levels are guaranteed.  Gold has always been the best asset to own after excessive central-bank money printing.  And when the world’s traders realize inflation is the real threat, not deflation, they will start flocking back to the yellow metal.

 

Adam Hamilton, CPA     October 2, 2015     Subscribe