Why There's No Real Inflation

Martin Hutchinson writes: According to Milton Friedman, "inflation is always and everywhere a monetary phenomenon."

If that is true, then you have to wonder where the heck all of the inflation is.

Every central bank in the Western world is holding interest rates down, and almost all of them are printing money like it's going out of style.

Five years ago, nearly every economist in the world would have told you this would cause inflation to skyrocket, and the big deficits governments were running would make matters even worse.

Taken together, monetary and fiscal policies are far more extreme than they have ever been.

Yet, inflation has remained rather tame at 2%. In Friedman's world that just wouldn't be possible.

It means even Nobel Prize-winning economists can get it wrong-at least in the short run.

Here's why Friedman has been wrong on inflation so far. It starts with his basic theory.

The central equation of Friedman's monetary theory is M*V=P*Y, where M is the money supply, Y is Gross Domestic Product, P is the price level and V is the "velocity" of money, thought of intuitively as the speed at which money moves around the economy.

In this case, the M2 money supply has been increased by 11.5% in the last two months and 8.2% in the past year, while the St. Louis Fed's Money of Zero Maturity (the nearest we can get to the old M3) has increased by 13.1% in the last two months and 8.4% in the last year.

Since GDP is increasing at barely 2%, that ought to mean prices should increase by 6%, just based on the last year's data alone.

Needless to say, that's not happening, since consumer price inflation is under 2%.

Of course, monetarists will tell you that money supply produces inflation only with a lag.

Fine, but it's also true that the M2 money supply has been increasing by 7.4% over the last five years. Admittedly, there was a year in mid-2009-2010 when it stayed flat, but otherwise the monetary base has been increasing at about 8-10% per year.

Again, growth in those five years has been below 2%, and five years is longer than anyone thinks the lag should be. So why isn't inflation at least 5% not 2%?

Monetarists would explain that by telling you that monetary velocity has declined over the last five years.

That's obvious from the equation, but what is monetary velocity and why has it declined?

The velocity of money is simply the average frequency with which a unit of money is spent in a specific period of time. And in our day-to-day activities, it's obvious that monetary velocity has in fact increased.

More people are using debit cards, which cause transactions to move instantaneously from the bank account to the merchant, and many people are using Internet banking, which similarly increases the speed of transactions, reducing both the amount of physical cash carried and the time that old-fashioned checks spend sitting in storage at the U.S. Postal Service.

Monetarists will tell you that the decline in monetary velocity is due to the massive balances, over $1 trillion, which the banks have on deposit with the Fed, which just sit there and do nothing.

That's probably correct since while the deposits exist, the ordinary mechanisms of monetary movement simply don't work, since that money has no velocity.

As a result, Bernanke and his overseas cohorts have succeeded in saving themselves from being hindered by a surge in inflation.

The Japanese experience over the last 20 years suggests that this position, with a huge money supply and no inflation, may continue for 20 years or more.

In short, thanks to the banks, Freidman's monetary theory has simply stopped working.

It's not clear to me whether at some point the banks will start lending the trillion-dollar balances at the Fed, in which case inflation will revive rapidly.

Austrian economists like Ludwig von Mises will tell you that ultra-low interest rates will create an orgy of speculation, in which markets create a huge volume of "malinvestment" - investment that should not economically have been made, and which has less value than its cost.

Eventually-like it did in 1929, the volume of malinvestment becomes so great that a crash occurs, in which all the bad investments have to be written off, huge losses are taken and a wave of bankruptcies sweeps across the economy.

This didn't happen in Japan. The banks went on lending to bad companies, creating a collection of zombies which sapped the vitality from the Japanese economy and has produced more than 20 years of economic stagnation.

In Japan, the politicians have even decided to print more money and do still more deficit spending. Since Japan has debt of 230% of GDP this will almost certainly produce a crisis of confidence, in which buyers stop buying Japan Government Bonds. That will cause the government to default and will more or less shut down the Japanese economy - the worst possible outcome.

At that point, you're likely to get all the inflation you want - it's basically what happened in the German Weimar Republic in 1923.

The point is, Bernanke has created something of a new monetary ground, increasing the money supply rapidly without getting inflation. But it won't last.

For investors the action to take is obvious: Buy gold. At some point fairly soon, you'll need it.

Since politicians hate periods of liquidation, they could encourage the same behavior here, in which case growth will continue at current sluggish rates until the Federal deficit becomes so great that nobody will buy U.S. Treasuries. Again, without a Treasury market, there will be an economic collapse.
At that point, you're likely to get all the inflation you want - it's basically what happened in the German Weimar Republic in 1923.

Lots of folks have stopped buying our Treasuries - the 'solution'? We buy them. It's getting nutty...

"To say there is no inflation is to ignore the commodity markets."

BTTT!

Double-digit commodity inflation. The only things that haven't inflated much in price are goods manufactured overseas. So not much overall "consumer" inflation (as measured by official CPI), but plenty of "producer" inflation.

Companies getting their margins hammered by commodity inflation move to protect their margins. They cut costs anywhere they can, and that mostly means cutting payrolls and R&D budgets. These companies don't hire, don't innovate, and eventually close due to margin compression. Supply-shock happens when PPI outstrips CPI. Some people use the expression "stagflation", but I like "supply-shock" better, as it can happen even during periods of relatively low inflation (that is if you trust the numbers coming out of the BLS). Manufacturing firms are especially vulnerable, since their consumption of commodity is much higher as a percentage of overall expenses.

Anytime that red line sits higher than the blue one, it's bad news for goods producers (and the employment market).

Very informative reply so thank you. I read an article a while back on actual inflation vs. core inflation. The reason for only measuring core inflation is that food and energy is seen as volatile and the theory is the two will normalize over time. I analogize it to EBITDA vs. Actual cash flow over time- eventually they will equal out. However, a study was done and found that actual inflation over time was 5% higher than core inflation. At first glance, this did not seem significant to me given the 10 year period, but apparently to much smarter statisticians this was a significant variance.

If they issued the mandatory gold buyout order, would you comply? Didn’t think so. Nor will your neighbors or anyone else with a brain.

The only two people who know I own gold are my wife and myself and, at this point in time, neither one of us work for the government.

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