Tag Archives: higher inflation

Why Isn’t Inflation Higher – part 2

In this second part of our article on why isn’t inflation higher we look at the relationship between the monetary base and the money in circulation.

Even though the monetary base has increased fourfold in the last ten years we still aren’t seeing the flow-through effect of this into the real economy. Banks aren’t lending normally today, partly due to their impaired balance sheets but also due to regulation and less risk taking.

As many small business owners and individuals have noticed it’s not easy to get a loan today as you will have to make it through cumbersome loan application processes. It’s mostly the banks and big institutions that have access to capital currently.

The graph below illustrates the difference between growth in M1 money supply (M0 and M1, also called narrow money, normally include coins and notes in circulation and other money equivalents that are easily convertible into cash) and the M2 money supply (M2 includes M1 plus short-term time deposits in banks and 24-hour money market funds).

why_isnt_inflation_higher_2 copy

Source: www.data360.org

The M2 money supply serves as a good indicator of money in circulation, which easily can drive price increases in goods and services. Clearly, we aren’t seeing much of a spillover effect of the M1 money supply into the real economy. Since 2009 increase in bank loans have furthrmore almost been flat.

So while we are seeing increasing asset price inflation, primarily in real estate and in the stock market, as well as a general increase in the cost of goods and services, we aren’t seeing it on a scale that would be proportionate to the actual increase in the monetary base. If that were the case then inflation would be considerably higher. Even though we gradually are heading in that direction, since money is seeping through the economy, it can be of interest to look into this topic further.

What are the prospects for a shift in the flow-through effect of money and what would be the catalysts?

The prospects for even higher inflation almost seem inevitable, as we’ve discussed before. Rising inflation can happen slowly as the velocity of money increases or with an external event like a shock sell off in the bond markets.

When it comes to the Feds stimulus efforts there is no way for them to extract themselves from the market without serious repercussions. Tapering the stimulus, which is closely linked to the discussion of extraction, is furthermore something which the Fed would have a very difficult time to do, as it would create significant turbulence in the bond markets.

As other central banks are decreasing their purchases of U.S. government debt, as illustrated by the graph below, the Fed has actually stepped forward as the single biggest buyer.

why_isnt_inflation_higher_3 copy

Source: Reuters

Between the start of QE3 in the beginning of 2013 and July 2013 the Fed have purchased 90.5% of net issuance of gross federal debt according to ShadowStats.com.

This is not a sustainable situation. It’s furthermore not a situation which the Fed ultimately will control since they don’t control long term interest rates. Inflation will continue to increase but with a crack in the treasury markets we could see a significant shift in the M2 vs M1 money supply, resulting in a rapidly increasing level of inflation.

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Why Isn’t Inflation Higher – part 1

Recently we discussed how the official U.S. CPI data is flawed as it excludes and replaces certain items, as well as “adapts” the relative increases in costs for goods and services used to calculate inflation. The end result being considerably lower inflation numbers than would be the case with for example the calculation methodology used prior to 1980.

In this article we take a look at the question: why isn’t inflation higher?

Real inflation, experienced by citizens, is definitely higher than the data the U.S. government publishes. Official U.S. inflation is below 2%. However, alternative methods of calculation – as well as some surveys – puts inflation between 4-10%.

The U.S. is not the only country that experiences price inflation though. In most countries the costs of goods and services are increasing and real wage growth is not keeping up pace – leading to a loss of purchasing power and wealth.

The reason behind the increase in inflation is primarily the stimulus packages that most governments launched in the wake of the credit crunch in 2008. The U.S. is probably the best example, but many other countries have followed suit. In fact, in 2009 all G-20 countries were on some sort of stimulus plan.

Today, Japan also stands out with a $1.4 trillion 2-year stimulus package in an effort to double the monetary base. The ECB in Europe, China, South Korea and a host of other countries are on similar programs.

Even though inflation clearly is higher than what the government says one can make some interesting observations when looking at how much the monetary base has grown and how much money we actually see in circulation. Doing so will reveal that we have yet to see significantly higher inflation numbers – maybe even hyper-inflation.

The graph below illustrates the St. Louis Fed’s measure of the monetary base – which is made up of bank reserves plus cash in circulation.

inflation-higher-official-numbers-gold

Source: U.S. Department of Labour

Between 2000 and 2012 the monetary base grew fourfold. Before the crisis in 2008 it was around $850 billion with approximately $40 billion in bank reserves. As a result of the significant QE1-3 programs today’s monetary base in the U.S. is around $3.2 trillion with more than $2 trillion in bank reserves.

Under more normal market conditions such a significant increase would flow over into the actual money supply. This has indeed happened, which is why asset prices have started to increase, but not to the extent that you would expect. The markets are behaving far from normal these days.

In the next part of this article we are looking closer at what we can expect going forward and why inflation is likely to increase.

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