Inflation
We received the latest inflation figures last week and they were up, down, and sideways. The CPI headline rate was up 0.4%. This was one of the sharpest increases in many months. But the year over year core inflation rate actually fell from 1.8% to 1.7%. And the core rate on a month over month basis remained the same at 0.1%. So what are we to make of the inflation rate?
For me, I look at the most recent monthly CPI rate. The month over month rate rose substantially to 0.4%. To me this is significant since it is inflationary expectations that matter, and that is determined by individual consumers and investors on a day-by-day basis. If you see gas prices and food prices rising suddenly, you begin to think about how much you'll have to pay next month and over the next year. If you believe prices will escalate, you tend to buy now at the cheapest price you can rather than wait. It's the same with investors. They start bidding up the price of money to compensate themselves for the lower value of money they expect to receive in the future.
So, when there is a turn in the trend of inflation from down to up, it is common for interest rates to follow. If you’re an investor and you think you're going to lose 1% in the next year to inflation, you need to be compensated by 1% on the return on your money. Otherwise you'll lose money. There is no mystery why interest rates just spiked on the long end from 1.5% on the ten year bond to 2.25%. The market is expecting inflation to be about three quarters of a percent higher for the next year.
Looking at the year over year rate does nothing to clarify the future. The fact that year over year inflation fell from 1.8% to 1.7% only tells us what already happened -- not what's going to happen. The long end of interest rates is telling us inflation may move up to the 2.5% level over the next year. This, of course, is not written in stone. Things can change next week again and the market may re-calculate its expectations. That’s what the market does constantly.
Many economists ignore the headline numbers and focus strictly on the core rate of inflation. The core rate eliminates things like food and energy prices since they are more volatile. They prefer to smooth and adjust the level over time -- and that's fine. But one needs to ask what causes inflationary expectations to change? It is real time inflation that changes expectations, not the past years’ experience.
Personally, when I want to get a handle on what's happening with inflation, I do not want to ignore a huge spike or fall in gas prices or food prices. Inflation is psychological by its very nature, and I suggest that ignoring what is happening at the grocery store or the gas station would be a mistake. For me, it's the raw real-time evidence that affects consumers and investors on a daily basis that is the best gauge of the direction and degree of inflation.
The Money Supply
Most conservatives and libertarians believe that inflation is caused by an increase in the money supply. This is the school of Monetarism taught by Milton Friedman. I have noted many times in past articles that I am not a monetarist. The reason is that there are errors in the theory. However, much of what monetarism holds to be true should not be ignored since it has proved to be correct at times. It’s kind of like technical analysis which has its pluses along with its flaws. Both technical analysis and monetarism are quantitative studies of money and markets. The problem with both is that economics is not a matter of math; it's a matter of values, and those cannot be quantified.
For example, I always follow the money supply figures even though they are only a guide and can be deceiving at times. An increase or decrease of a nation’s money stock can lead to inflation or deflation. The thing to keep in mind is the word "can". We have seen the Fed create 3.5 trillion dollars of new money over the years since the financial crisis and inflation fell. The reason is that it all depends on what the money is used for as to its inflationary impact. Ludwig von Mises proposed the monetary theory that best describes the cause of inflation. It boils down to how individuals value money. If they dis-value it, they get rid of it for something more valuable, causing inflation; while if they value it they hoard it, which can bring on deflation.
In today's era of fear and distrust, investors and consumers alike have grown more cautious, therefore less money is demanded for consumption while more money is being saved and protected. It is an era of paradox as we witness tight money even while the world is awash in newly created money. This is why monetarism is a flawed theory while Ludwig von Mises Subject Theory of Value has been proven correct. Once again, it's not a matter of math; it's a matter of human values and human action.
But for our purposes we will define inflation in the popularly accepted sense as an increase of the money supply that leads to an across the board increase in prices. Note that there are two parts to this definition -- not just an increase in money supply, but one that leads to higher prices across the board. Proponents of Monetarism seem to forget the second part of the definition and hold the first part to be sacrosanct. The error is in separating cause and effect. An increase in the money supply is a potential, not an inevitability as some would have you believe.
For the last 25 years, no matter which measurement tool you use, prices have been declining as a percentage of increase. We've had inflation, but the rate has decreased markedly since the days of double digit inflation. Through all of those years I have continued to hear with some amazement and amusement the relentless warnings of the inevitability of hyper-inflation. And in spite of the fact that the rate of inflation fell for all those years, the volume of the warnings of the "true believers" increased.
Another definition used by Milton Friedman was that inflation was more money chasing less goods leading to higher and higher prices. This is a good common sense way of looking at inflation. Like I say, I follow the money supply because all things remaining equal if there is a major increase or decrease in the rate of growth of money, individuals may find money becoming easier or harder to get - and that will affect their consuming and investment decisions. That will sometimes affect prices. It is ironic in this era of record increases of money, that money is hard to get. It just goes to show that all things do not remain equal.
Nevertheless, a sudden and substantial change in a nation’s money supply, more times than not, leads to a change in the degree of economic growth and inflation. So it bears watching. And I do.
The question then becomes if we are to monitor the money supply, which gauge of money should one look at? Money supply is basically broken down to M1, M2 and M3. In its simplest form, M1 is defined as cash on hand and checking accounts. M2 is that plus saving accounts. And M3 is all of those plus money market accounts. There's more, but this is sufficient to make the following point: M2 represents cash immediately available for purchases or investments. Cash available on demand, if used, can move prices and markets in a day in these times. So I choose M2 to follow.
But then there is seasonally adjusted (SA) and non-seasonally adjusted (NSA) money supply to choose from. I go with non-seasonally adjusted figures. The reason is I want to know exactly how much real money there is at any one time in the banking system to tap. SA money supply gives me theory. NSA gives me raw data. I also must choose between viewing monthly statistics or weekly figures. I choose weekly for the obvious reason: I want to be as current as possible.
Here are the money supply figures I monitor. Click here: Browse FRB Money Stock Data
The second row shows you M2, and to the left of it is NSA weekly. Also above on the left hand corner you will see “velocity”. At the end of every week, these figures are updated. If you look at the growth of M2 over the last many months, you will see that there has been no change in that number. This is highly unusual. Money supply in the modern era has generally grown at around a 5-10% rate. It has been stagnant lately. And if you click on the velocity of M2, it should be level to rising. It has fallen continuously.
This concerns me. Normally a falling or even stagnant money supply for any length of time leads to a deflationary recession. But like all things economic, one needs to take statistics and data in context. Perhaps the money supply is "lying". In other words, it may not be signaling normal times. It could be a temporary aberration affected by the steep climb of the dollar recently which made imports abroad cheaper. Money probably flowed out of this country to seek cheaper goods elsewhere. But still, that’s deflationary -- less money chasing more goods at home.
When Alan Greenspan was asked what he watches when making monetary policy, he answered, “everything!”. Money supply and velocity of money is just one more thing to watch, but an important one. According to Monetarist theory, it takes about six to nine months for a change in money supply to affect the economy. The money supply has been stagnant since mid-February. That puts us about half way through the time lag. Monetarism is sometimes right; therefore I'll be monitoring the economy for any unusual change in direction in the future.
Gold
Also, it’s worth noting that when the money supply stopped increasing and went stagnant in February, gold began to fall. The money supply has remained stagnant since, and gold has flat-lined. This is not unusual, in fact it's quite normal. Gold is a competing money of sorts, and when dollars become scarce gold tends to turn neutral to negative. And when dollars are plentiful, gold tends to rise. I’m not suggesting there’s a mathematical correlation, but just another thing to be aware of. Gold, like the money supply, is a good barometer of potential inflation at times.
At this point I see inflation rising, growth rising, and fear subsiding. For me markets and economies move based on the values and actions of individuals. Nevertheless, like charts and technical analysis, I'll keep an eye on what admittedly is a very rare occurrence going on with the money supply, and hopefully it will rectify itself in the weeks and months to come and is not signaling the onslaught of a deflationary recession.
One more point before wrapping up this discussion on Monetary Theory. Many gold bugs claim that gold should actually be much, much higher. Some put that "actual" figure at $5000 an ounce, $10,000 an ounce, or even $20,000 an ounce. They claim to know what the market does not. They use math to prove their theory. This is a derivative of Monetarism, or what's known as the Quantity Theory of Money.
It's simple: you take the amount of fiat dollars and all money substitutes outstanding that can be converted into gold, and divide the amount of gold by the amount of claims to it. That gives you the "real" price of gold. The problem with this theory is that it ignores human values. If and when people begin to convert their dollars for gold and gold skyrockets, at some point it pays people to take profits by selling their gold to pay off debts, or buy a house, or a new car, or take a vacation due to their windfall profit. Dollars are not just convertible into gold, but all other things. This is what happened as a run on gold ended at just over $1900 dollars an ounce and people converted from gold to other goods and investments. I was one of them. All things do not remain equal. Values change.
Market value trumps mathematical formulas. Markets never correspond to anything so rigged as math, charts, or graphs. These are just tools, as are the money supply and the economic data we so closely look at for clues as to which way the economy, inflation, interest rates, stocks, and commodities are heading.
That's what makes this particular "science" so interesting -- it's always changing.