By
The
Inflation Trader
:
While the markets are relatively quiet - bond yields rose
slightly Thursday and stocks were essentially flat; only
commodities were reasonably buoyant - it may be a good time to
examine the case for an acceleration of inflation and the risks to
that case.
Inflation does not derive from excessive growth, nor deflation
from excessive slack. While certain goods and services may
experience
relative
price increases or decreases due to the microeconomic conditions of
supply and demand, there aren't any convincing examples of that
happening for "aggregate" supply and demand in the absence of
accommodating money supply growth. The clearest counterexample to
the notion that growth and inflation are intimately interrelated is
that in the period just past, the greatest recession in almost a
century, year-on-year core inflation
never declined
, and if we remove the effect of the deflating bubble in housing,
core prices in the rest of the economy never increased less than
1.1% on a year-on-year basis (see Chart, Source:
Enduring Investments
).
Nor is the expansion or contraction of the monetary base the key
element in inflation. At one time, when the money multiplier that
maps base money into transactional money (e.g., M2) was relatively
stable, it didn't matter if one used the monetary base - it was
incorrect, but the relationship was stable so it didn't matter.
Once the Fed started paying interest on excess reserves, however,
the relationship between base money and transactional money was
artificially severed and it now matters which aggregate one uses.
(See Chart, Source Bloomberg, which shows M2 divided by base
money).
When the crisis hit, the velocity of money plunged as commercial
bank lending dried up. The Federal Reserve properly countered this
drop in velocity by pumping up the raw quantity of money. They did
so in an awkward fashion; paying IOER meant the central bank had to
add a
lot
more base money to cause M2 to rise appreciably, but it worked and
prices as noted above never declined.
Now, commercial bank credit in the U.S. is expanding again,
auguring a turn higher in money velocity in the near future. And
yet, the Federal Reserve and other central banks continue to add
money, setting up the potential for a long-tail inflation accident
if velocity rebounds and the central banks do not begin to tighten
in advance of that event. (I find that an extremely unlikely
possibility, with unemployment over 8% in the U.S. and no longer
falling, and at least one Fed President calling for unlimited QE.)
That doesn't mean that we
will
get an inflation spike; in fact, year-on-year M2 growth is now
under 7% here in the U.S. If money velocity doesn't pick up, then
core inflation may only rise slowly from here.
But all of that presumes a closed system where only the U.S.
central bank affects the money supply that matters. Unfortunately,
or perhaps fortunately, that isn't the case. Inflation is
substantially a
global
phenomenon, and here lies the potential for both optimism and
pessimism on inflation.
On the pessimistic side, one must note that even if the Fed does
not in fact pursue further QE, other central banks are sure to
continue to do so. The Bank of Japan is not about to stop easing
when core inflation in that nation remains below zero. The BOE
continues to ease and the ECB has little choice but to ease further
(or so they believe), and even the relatively responsible RBA is
likely to keep money easy with China's slowdown threatening on its
doorstep. More money, all else equal, means more global inflation,
and more global inflation - unless the U.S. dollar undertakes a
serious and extensive appreciation - means more domestic
inflation.
But on the optimistic side - for inflation, anyway - European
money velocity may be on the verge of collapsing. If you want to
make a case for slowing U.S. inflation, I do not believe you can
look to the U.S., but rather must look to Europe. If domestic
lending (and hence velocity) is rising partly because European
lending (and velocity) is contracting, then some of the inflation
potential is being sucked out, at least temporarily, by financial
and credit strains in Europe.
In my view, the only plausible way we get appreciably
lower
inflation is if central banks abruptly stop quantitative easing (I
don't think there's any measurable chance that they
tighten
) and the velocity of money in Europe (and Japan) drops faster than
the velocity of money in the U.S. rises. In fact, I can make up a
deflationary scenario, in which U.S. velocity rolls back over -
perhaps because of some unforeseen consequence of the Volcker and
conflict-of-interest rules, which some believe may impair
securitization markets if the regulators don't clarify certain
issues - and central banks actually choose that moment to swear off
QE.
It's very unlikely - mainly because I don't think central banks
will ever do more than
pretend
to care about inflation, and will keep on adding QE until inflation
is not just a danger, but actually high enough that it becomes
considered a bigger problem than persistently high
unemployment.
However, if I'm wrong, I think the 'optimistic' (in a sense)
scenario above is how mild disinflation could come to pass.
See also
Combining The Volatility And Value Anomalies
on seekingalpha.com