“The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague. Inflation is a policy.” Ludwig von Mises.
The Bank for International Settlements (the central bank of central banks) pinpointed the issue, perhaps accidentally, in a recent study when it stated:
“In recent years, when judged against traditional macroeconomic yardsticks, developments in global interest rates and measures of “liquidity” have been remarkable. It is hard to find a period in the postwar era in which inflation-adjusted interest rates have been so low for so long and monetary and credit aggregates have expanded so much without igniting inflation.
Many economists appear to regard this as the promised land of permanent growth and prosperity. As if somehow, there is some magic at work that has lasted so long it must be forever. However, it is ultimately a highly unstable set of circumstances. The trick here is to understand that, in reality, we are currently in a period of rampant inflation, albeit heavily disguised, and that once this is properly understood it should completely alter your whole investment outlook and assessment of market risk and tactics.
The chart above shows that, according to the IMF, global foreign exchange reserves have been rising at an incredible rate in recent years. More than doubling in just five years. This is the amount of each others fiat currency that central banks own, and by far the greatest increase has been in holdings of the US dollar. Now central banks are beginning to wonder whether or not they really need to own so many US dollars. For the moment, however, there does not seem to be an easy alternative, and reducing their dollars holdings could be highly destabilizing.
The US has run a large and expanding trade deficit for many years, a deficit that has stemmed primarily from the massive US$ money supply expansion that occurred during the late-1990s and the first few years of the current decade. The large and growing US trade deficit has helped to mask the ‘bad’ effects of this inflation — rises in the prices of the things that form part of the Consumer Price Index (CPI). The current system shifts the inflationary effects from goods and services to assets and investments. Let’s explain how this works.
The excessive expansion in the money supply in the US would normally lead to a substantial increase in domestic prices. However, to a great extent, the excess dollars have been spent on overseas goods. This has reduced the pressure on domestic prices but has led to a massive increase in the trade deficit. The other consequence is that this has flooded overseas producers with US dollars. Unless foreigners hoard the sizable amount of dollars they receive selling their goods to the US, then most of the dollars that flow out of the US on the trade account will end up flowing back into the US on the capital account, bidding up the prices of assets and investments. The beauty of this recycling is that this diverts the inflationary effects of the massive expansion in money supply, particularly in the US, away from the things measured by the CPI to the things that most people are happy to see rising in price, or don’t really care about. No one seems to be too worried about the incredible rise in house prices or stock markets, and few seem to care about explosive commodity prices.
This is a wonderful system for the tiny minority who understand how it works, but it is also ultimately disastrous for the great majority of people who believe that inflation is accurately reflected by published price indices, which are regularly and commonly called inflation, particularly by the central banks, including the Bank for International Settlements above. This is a dangerous, misleading, and incorrect definition, and in the longer term massive inflation has always ended up doing more harm than good for the great majority.
“What people today call inflation is not inflation” – Ludwig von Mises.
Simply put the correct definition of inflation is the increase in the quantity of money and money substitutes.
Changes in the cost of living index, whether it’s called a consumer price index or retail price index, is one of the consequences of monetary inflation, but not really what inflation is. This is not semantics. This completely changes the way in which markets and the economy work, and the correct definition provides a far sounder basis for understanding what is happening in the financial world.
Consumer prices are a measure of the cost of living, but this has limited value as a guide. For several reasons:
For all these reasons cost of living indexes are very far from ideal and are often highly misleading. This is particularly the case when a huge gap emerges between these price indices and money supply, which has clearly occurred in recent years.
While in the developed world price index inflation is for the most part around 2% to 3%, and much lower in Japan. Money supply growth all around the world is much higher. In the US the government has stopped reporting M3 (out of embarrassment?), which would tell us how much the currency in circulation is growing. Other sources, though, keep tabs on it.
Shadowstats.com tells us that M3 is increasing at an annual rate between 10% and 11% – or about three times as fast as the economy itself. But M3 is not the only source of liquidity. Foreign governments need to try to keep up with the dollar, by issuing more of their own paper. And derivatives, leveraged debt, and other gimmicks in the financial industry have the effect of adding billions to the system. The Economist estimates that liquidity itself has been on the rise at 18% annually for the past four years.
So price indices are underestimating money supply inflation by a substantial amount, and using a measure of money inflation would significantly change the way you look at both your investments and the economy. For example, investors who believe that they are doing well in their “safe” cash deposits earning between 1% and 5.25%, in recent years, have simply locked themselves into a certain loss of real purchasing power, as they watch house and commodity prices explode higher. Another consequence is that real growth in the economy may be substantially overstated.
Furthermore, this is not a temporary aberration in money supply policy. It will be standard procedure for the foreseeable future. Unfortunately, the best guess is that rampant money supply inflation is here to stay. In addition to running a large trade deficit, the US runs a large budget deficit and has astronomical non-funded liabilities. In this respect, however, the US is in good company in that most other developed economies are in similar straits. However, this will still mean that there is a very high probability that the US Government will resort to further rampant inflation over the coming years in an effort to make good on its spiraling financial obligations. This is a reason to be long-term bearish on the US$ relative to gold, but not necessarily a reason to be long-term bearish on the US$ relative to most other fiat currencies, which are also expanding their money supply at a rapid rate.
Excessive money supply well in excess of consumer prices and interest rates, together with the exploding trade deficit and US dollar reserve holdings is a massively inflationary policy. This is not widely understood because the price index impact of this system falls outside consumer prices and “inflation” is usually defined incorrectly.
Investors need to re-evaluate their whole approach to investment once they see that the true inflation picture is radically different from what is generally understood. Central banks talk a great deal about controlling inflation, but in reality, their greatest fear is slow growth, deflation, and bankruptcy. This is why interest rates have remained so low for so long, and may yet continue to do so.
Nevertheless do not be mistaken. Central banks are involved in a highly interventionist and inflationary policy. This policy will continue indefinitely as the budget deficit and the level of debt generally in the US has never been greater. Any change in this policy would greatly increase the risk of deflation, which is the worst outcome for the banking system. Indeed, at this point, inflation looks like the only feasible policy.
As Ludwig von Mises put it, “Inflation and credit expansion, the preferred methods of present-day openhandedness, do not add anything to the number of resources available. They make some people more prosperous, but only to the extent that they make others poorer.”
Make sure you are on the right side of this equation.