Over the past two years, the United States government and the Federal Reserve
have dispersed trillions of public dollars, run up enormous deficits, and kept
interest rates at zero. In just about any economic textbook, this combination
of policies would be described as the perfect recipe for inflation.
Yet, with the exception of the usual increases in healthcare and education,
prices by and large are not rising. Many have concluded that our economic
leadership has simply outsmarted the textbooks.
The benign Consumer Price Index (CPI) figures are serving as a rallying point
behind which the financial talking-heads are forming
a parade of optimism. The low CPI is their "proof" that inflation is not a
pressing concern. This view is two dimensional.
Inflation is classically described simply as an increase in the money supply.
Although these changes will impact price levels, it doesn't necessarily follow
that prices will rise when inflation is high. Instead, inflation may merely
result in stable prices at a time when prices would otherwise be falling.
In the popular mentality, however, inflation is simply defined as prices
rising. After decades of steadily rising prices, people seem to have forgotten
that prices sometimes fall. In light of the bursting of a number of
record-breaking, government-fueled asset bubbles, prices should be declining
across the board (as they did in the Great Depression). The fact that prices
are stable, or have even rallied in some sectors, indicates that inflation is
already spreading across the economy.
After falling to just 6,547 in the months after the crash, the Dow has rallied
past the 10,000 mark. This should strike even novice investors as unjustified.
Jobs are still being lost, a massive healthcare entitlement and carbon tax are
winding through Congress, and no one with at least one foot in the real world
has a palpable sense of imminent recovery. Corporate earnings have fallen far
behind the rally in shares prices, stretching valuation multiples to pre-crash
levels.
While not quite as frothy, home prices are now moving up for all the wrong
reasons. The seminal Case-Shiller Index of home prices is now up for the fourth
month in a row. The index's designer, Professor Robert Shiller, has stated
recently that the current upward trajectory is unsustainable. In fact, the
levels are still above the 50- and 100-year trend lines.
In the worst economic climate since the Great Depression, and after the largest
housing bust on memory, single-family home prices should be falling well below
the trend lines. But with a doubling of the monetary base and special interest
programs like the homebuyers' tax credit, home prices have stabilized and even
increased in some markets. That's the work of inflation.
With gross domestic product growth now returning to positive territory, many
inflation hawks ask why inflation has yet to truly manifest. The explanation
can be found in the difference between monetary base and money supply.
The latest US$1.9 trillion injection of government money was composed of some
$900 billion of stimulus, of which only about 20% has been distributed.
However, in its attempts to stabilize the financial system, the government has
already spent some $1 trillion of Troubled Asset Relief Program (TARP) type
funds.
The TARP money, financed by an increase in the monetary base, has been provided
to the banks at zero cost. And for the first time, the Fed is paying interest
on bank reserves. Therefore, the banks can lend money to the Fed and to the
government via Treasury securities at an interest rate spread of some 3% to 4%
without risk. Given these incentives, it makes no sense to lend to anybody
else. So, despite a massive increase in the monetary base, credit remains tight
and price levels flat.
However, if the Fed stops paying interest on bank reserves or otherwise
"persuades" the banks to lend, the $1 trillion will be leveraged up by the
banks and spewed out into the economy. Fractional reserve banking will
transform a $1 trillion monetary base injection into a $9 trillion increase in
money supply. When that happens, prices for everything will go through the
roof.
So for now, inflation is like a ninja stalking our economy. It's lurking in the
shadows but can't easily be seen. But once its strikes, it will be fast and
deadly.
John Browne is senior market strategist, Euro Pacific Capital.
Euro Pacific Capital commentary and market news is available at
http://www.europac.net. It has a free on-line investment newsletter.
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