The total US money supply (M3) has expanded at a 10% annualised rate since mid-May and is up by around 7.5% over the past 12 months. This rapid rate of money-supply growth is making a mockery of the Fed's monetary tightening, but there are good reasons to expect that the situation will change in the near future.
Borrowing associated with residential real estate, whether it be the establishment of new mortgages or the re-financing of existing mortgages or the taking out of home equity loans, has been the biggest influence on the US money-supply growth rate over the past 10 years. And money-supply growth from this source has already begun to taper-off and is very likely to fall further. Evidence that this is the case includes:
a) The rate of growth in home equity loans has plunged over the past few months and will probably continue its downward trend due to a general softening of the real estate market
b) The index of mortgage applications calculated by the Mortgage Bankers Association recently hit a 9-month low
c) Trends in mortgage applications move counter to trends in long-term interest rates. Furthermore, significant trend changes in long-term interest rates generally lead significant trend changes in year-over-year money-supply growth rates by about 3 months. With long-term interest rates having trended higher over the past two months and having just moved to near their highest levels of the past year we should see the beginning of a downward trend in the rate of money-supply growth within the next few weeks.
Although year-over-year growth rates in the broadest measures of US money supply (M2 and M3) have moved higher over the past six months, the bigger picture -- as shown on the following chart of the year-over-year M2 growth rate -- is that a downward trend has been in force since the beginning of 2002.
Our view is that the peak in inflation (money supply growth) that occurred during the months following the Sep-2001 terrorist attacks will turn out to be the peak for this decade. (Ironically, the peak in inflation appears to have occurred at around the same time as the fear of inflation was at a multi-decade low). However, we expect gold -- the ultimate inflation play -- to perform extremely well over the next several years for two reasons. First, the effects of the massive inflation of 1997-2002 will be rippling through the economy and the financial system for many years to come. Second, even though we are unlikely to see the sort of percentage gains in the money supply over the next few years that we saw during the early part of this decade, the greatest beneficiaries of whatever inflation does occur will be the things that are in long-term bull markets. And make no mistake; there WILL be plenty of inflation over the next few years.
When analysts argue for a deflationary outcome it is generally because they expect prices to fall. However, price declines that are not CAUSED by a contraction in the total supply of money and credit are not related to deflation in any way. For example, the prices of most things made in China will probably continue to slide almost regardless of how much inflation (money supply growth) there is in the world.
The primary reason why there will be more inflation over the next several years is that genuine deflation -- a contraction in the supply of money and credit -- is not an option. It's not, for instance, feasible for there to be a 1-2 year period of deflation that washes away the current excesses and paves the way for the next expansion. This, in turn, relates to the way new money is borrowed into existence under today's monetary system. The problem, in a nutshell, is that when new money is created by the expansion of debt the amount of repayment obligations will always be much higher than the total supply of money (because each new dollar brings with it a liability in excess of one dollar due to the obligation to pay interest). Therefore, once the total amount of debt reaches a high level the inflation either continues or the system collapses. And in our opinion, we are a very long way from the point where the inevitable collapse occurs.
A secondary reason to anticipate a continuation of the inflation is that current liabilities are denominated in nominal dollars, not inflation-adjusted dollars. For example, the US Government has trillions of dollars of future social security obligations and US corporations have trillions of dollars of pension-related obligations, but no one is promising that these obligations will be met in real terms. Regardless of whether the dollar holds its purchasing power or loses 90% of its purchasing power over the coming 10 years, the number of dollars that will have to be paid to satisfy these obligations will remain the same. With this in mind, what are the chances that the Fed and the Government will do anything other than follow policies that erode the purchasing power of the dollar?
Ben Bernanke's November-2002 speech titled "Deflation: Making Sure It Doesn't Happen Here" caused a lot of controversy, but from our perspective the man who will be taking over from Alan Greenspan in January of 2006 was just stating the obvious. It is ridiculous to assert -- as some analysts regularly do -- that an institution with the power to create an unlimited amount of dollars would be powerless to continue the inflation; and that's regardless of whether inflation is correctly defined as an increase in the supply of money or incorrectly defined as an increase in the general price level. The aforementioned speech simply described some of the arrows in the Fed's quiver (refer to the part of the speech with the sub-heading "Curing Deflation" for details).
Over the coming year or two we doubt that the Fed will have to take any of the special measures outlined by Ben Bernanke. The amount of money-supply growth generated by the mortgage financing/re-financing industry looks set to decline over the coming one or two quarters, but we suspect that the US Government will take up a lot of the money/debt-creation slack. In particular, the massive increase in government spending associated with the re-building of New Orleans should add a few hundred billion to the money supply over the coming 2 years; and then there's the on-going spending associated with Iraq, the potential for more large-scale war-related spending/borrowing if Iran pushes forward with its nuclear program, the $300B of future government spending on roads and other surface transportation authorised by President Bush in August, spending/borrowing associated with preventing or combating a 'bird flu' pandemic, etc.
The bottom line is that the central bank and/or the government are quite capable of keeping the inflation going for many more years; and, as discussed above, they effectively have no choice other than to continue the inflation. What they can't do is control the effects of inflation, that is, they can't control which investments and which sectors of the economy will be the main beneficiaries of the inflation they create.
15 November 2005
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