Market Observation with James J Puplava CFP

James J Puplava CFP

The Three Faces of Inflation

By James J Puplava CFP, February 14, 2005

3 faces My weekly grocery bill has gone from $200 to over $300 a week in the last three years. That is significant in itself. However, I am only buying for three people versus five people three years ago. My oldest son has gone off on his own and my middle son has gotten married. My weekly food bill has gone up over 50% even though I now buy for a smaller family. My doctor charges me $80 for an office visit versus $60 the year before. My dentist has raised his fees from $45 to $58 for an office visit. It costs me $12 more to fill my gas tank each week and I'm spending $7 a day at the local deli versus $5 a few years ago. My property taxes just went up significantly and my health care premiums are up double-digits. The last time I went to the movies it cost me almost $60 for just the three of us. The cost of the movie was $29.25 the other $30 was for coke and popcorn.

While my living expenses are going up at 8-10 percent a year, I am constantly told that there is no inflation. Last Friday a Fed governor told the markets that inflation is well contained. There is a dichotomy between what I am told by Wall Street and what I actually experience on Main Street. The media and financial professionals are constantly telling me there is no inflation. Yet, what I experience in daily life shows me otherwise.

Ask the average Joe or the great majority of professionals to define inflation and they will tell you that it is rising prices. The problem with this definition is that it tells you nothing about its cause. The implication is that inflation is the result of somebody or someone raising prices - the butcher, the baker, the candlestick maker, or simply OPEC. If you accept this definition, it becomes easy for the average person to get confused. In essence inflation has no face and is causeless. If we accept the definition that inflation is simply rising prices, then the cure is price controls. After all if rising prices are the result of businessmen driven by the greed of higher prices, then the best way to control inflation is to initiate price controls. Already the media complains about higher energy prices and the absurd profits of oil companies. The cause of higher prices is OPEC and the greed of oil companies. Very seldom do you read about higher demand.

The real cause of inflation is an increase in the quantity of money. All inflations are a monetary event. They are the result of an increase in the quantity of money caused by government. Before we move further in our understanding of inflation, a short primer is necessary.

Definition

There is irrefutable evidence that government is the source of all inflation. An undue increase in the quantity of money is what stands behind a rise in prices. The source of all money or credit is government. Thinking of inflation only in terms of rising prices is similar to looking at the symptoms of a disease rather than the disease itself. A more exact definition of inflation would be an increase in the quantity of money and credit relative to available goods resulting in a substantial and continuing rise in the general price level, an increase in the quantity of money caused by government.

You will notice that this definition doesn't say anything about cost-push, profit-push, or crisis-push inflation. It simply states that the supply of money expands leading to higher prices. It is the expansion of money and not rising prices that leads to inflation. This also points to the real cause behind inflation as government intervention in the economy and financial system by expanding the supply of money and credit in the system.

Formula

When the government increases the supply of money and credit in the economy, it increases demand for goods leading to higher prices. Higher demand or lower supply is the only conceivable cause of higher prices. It can be demonstrated by the formula below: [Price Level = Demand/Supply]

P = Dc
Sc

To expand and elaborate on this formula, we must add a time factor, which is how long and how fast the holders of money decide to make it available. Lord John Maynard Keynes referred to this as "liquidity preference," or how much and how long the holders of money liked to keep it on hand. The reverse of this is called the velocity of money, which measures the volume of purchases relative to the supply of money. Money velocity is the hardest to understand because it is dictated by psychological factors. The volume of spending within an economic system is not only determined by the supply of money, but also by the demand for money. The greater the demand for money, the greater is the preference to hold it. (Keynes' liquidity preference) The smaller demand there is for money, the less preference there is by holders of money to want to hold or store it. Simply put, the greater the demand for money, the lower the velocity and the smaller the demand to hold money, the greater the velocity.

When individuals decide not to hold money and instead have a preference to spend it, the velocity of money increases. Likewise, when there are desires to hold money instead of spend it, the velocity of money decreases.

Therefore, to our quantity theory of money, we must add velocity to the equation. The new formula for price levels can then be stated as follows:

The new equation shows that the general level of prices moves in direct proportion to the quantity of money and its velocity. Price levels move in inverse proportion to the aggregate supply of real values. If money velocity is held constant, then price levels will depend on the quantity of money. It is only when people begin to distrust money and feel that the security of their money is being threatened that money velocity increases. When the value of money is insecure, the demand for it falls. There is less of a desire to hold it because its value is depreciating. People dispose of their money and find a replacement for it in tangible goods that are real. The desire to own commodities or real goods increases because these goods represent a better source for meeting future cash needs.

During the latter stages of inflation, money velocity increases because people no longer have faith in their currency. As shown in the chart below, the depreciation of the Reichmark increased as the supply of money expanded as did money velocity. Money velocity is a direct reflection of the degree of confidence that people have in their currency. A sharp increase in velocity normally takes places during the final stages of an inflationary crisis.

THREE TYPES OF INFLATION

The quantity theory of money is what connects the dots between an increase in the quantity of money to the rise in prices caused by greater demand. A growing quantity of money is what raises the demand for consumer goods through the issuance of new money that gets spent and re-spent as its rate of growth increases. It is exactly the new supply of money and credit in the system that enables consumers to buy more goods. What is not clearly understood by professionals or the public is that inflation, which is caused by excess money and credit, has three ways of expressing itself through: rising consumer prices, rising asset prices or a rising trade deficit. The standard definition accepted by the great majority of people as rising prices is incomplete. It doesn't take into account its cause nor does it cover all of its outward expression.

Inflation, Type 1: Rising Consumer prices

The first type of inflation is something that we are all familiar with which is rising consumer goods prices. As the graph below illustrates, consumer goods prices are up over 3.3% year-over-year.

Many feel that this figure is understated because of hedonic adjustments, which remove price increases as a result of quality adjustments. A few astute professionals believe that hedonic adjustments understate the CPI by 1-2 percent. Even then the CPI index is adjusted so often that rising prices of things that go up like housing are routinely adjusted to make them appear small. It is one reason that housing inflation appears modest after BLS adjustments. My doctor and dentist fees, which have risen by over 30 percent, don't get reported in the CPI. If they did, they would be adjusted lower to reflect the fact that I now have a nicer smile. Even the things that are going up double digits like food and energy are routinely dismissed and excluded from the calculations. If the CPI jumps as a result of higher energy or food prices, the price increases are treated as one-time events.

The problem for most consumers is that they can’tdismiss higher energy and food costs. They confront them every day. It is one reason why households are having a tougher time making ends meet. It also explains why credit card borrowing is up substantially. Over 60 percent of all credit card debt is used to buy basic necessities from food and gas for the car to unexpected doctor visits. There is a strange inconsistency between government attempts to mange the CPI level lower and the Fed's worries over inflation, which is why they are raising interest rates.

Inflation, Type 2: Rising trade deficit

The reason that consumer price increases have been relatively tame given the enormous expansion of money and credit is that excess demand has been channeled into imported goods. As the graph below illustrates U.S. private consumption hit new records last year as consumers spent more than $4 trillion. Commensurate with that demand was a record trade deficit that hit $672 billion last year.

What this graph illustrates is that exploding money and credit, which increased demand, was diverted away from domestic price channels into exploding demand for imported goods. If the U.S. economy was a closed economy and domestic demand could only be channeled into domestic goods, prices would be exploding. Therefore, a rising trade deficit is another manifestation of inflation. It is excess demand that is channeled into imports. The fact that the trade deficit is massive is an example of how far the inflationary spiral has been driven.

The trade deficit is what keeps goods prices from rising even higher. Domestic price levels are being suppressed by a soaring trade deficit, which absorbs excess credit induced demand. The soaring current account deficit is also responsible for understating domestic money supply. If the deficit couldn't be financed externally, the money supply would be more expansive. There wouldn't be enough domestic savings to finance the budget deficit. This would force the government to finance the budget deficits with newly created money through Fed monetization. Fed monetization is the purchase of government securities by the Federal Reserve System, which creates new and additional checking deposits for the Treasury. When deficits are financed in this manner they become inflationary. The U.S. government has been fortunate in that it has been able to rely on the kindness of strangers to finance its growing budget deficits. When this option is eliminated, monetization will begin.

Inflation, Type 3: Rising Asset Prices

Another avenue for inflation to express itself is through soaring asset prices. Over the last ten years the primary destination of money and credit has been into assets. In the 90's it was stocks. In this new century it has been channeled into bonds, mortgages, and real estate. When asset prices soar beyond reasonable limits, we refer to this type of inflation as a bull market. All reasonable measures of value have disappeared as a result. In the stock market P/E multiples, dividend yields, price-to-book/ price-to-sales ratios are all at historical extremes. In the bond market, credit spreads have all but disappeared. Interest rates are at half century lows despite soaring twin deficits here in the U.S. In real estate, housing prices are at extreme levels. Home ownership equity is down, rents are low in relation to property values, and real estate prices to consumer income are reaching new heights. The charts below of interest rates, credit spreads and P/E multiples are all examples of asset bubbles created by too much money chasing too few assets and overpaying for them.

At some point soon this money and credit orgy will come to an end. Foreigners may lose interest in financing America's perpetual deficits. With almost no savings, the real inflationary consequences of budget deficits and the trade deficit will begin to manifest itself through rising goods inflation. Analysts and anchors won't be able to as readily dismiss rising food and energy costs. After all, people have to eat, drive to work, and turn on the lights. A familiar pattern in history is about to play itself out with the same consequences. All inflations are and always have been primarily a monetary phenomenon. Under a fiat money system, with nothing to anchor money, governments have unlimited means to inflate.

FAMILIAR PATTERNS

What we are seeing unfold today is an all too familiar pattern in history. All great inflations have a common characteristic to them. We see the same sequence in development, same price patterns, and similar movement in wages, rents, and interest rates. They all begin in periods of prosperity and they all end tragically. You can’tdebase money without consequences.

In the previous price inflations of the 12th, 14th, 16th, 18th, and 20th centuries, money growth and population growth went hand-in-hand in creating higher prices. As a population grows people need more food, fuel, energy, and housing. Demand for basic necessities expands more rapidly than supply. This is exactly what we are seeing today with the industrialization of the developing world. Like previous price revolutions, the most rapid price increases appear in the price of energy, food, shelter, and raw materials. These are the items most in demand during periods of population growth and expansions in the supply of money. Demand starts at the bottom of the consumption chain and then works its way upward. Basic necessities are the least inelastic in their supply. As to the notion that the commodity bull market is over, think again. It has just begun. Has population growth stagnated in the developing world? Is the world's population growing or contracting? You need to put food on the table before you buy a new computer, cell phone or DVD player.

On the supply side, where are the new oil discoveries, the new refineries, the new pipelines, the new power plants and alternative sources of energy that will meet all of the worlds growing energy demands? Where are the new mining discoveries, the new mines that will meet the voracious appetite for steel, iron ore, alumina, zinc, nickel and lead? Where are the new gold and silver discoveries? Where are the new coffee, sugar, and cocoa plantations? Demand is growing, while supplies have diminished as a result of a multi-decade long bear market. Do the markets really think four years of price increases have eliminated the supply deficits?

We are heading towards the terminal and final stage of this price revolution that began in the 20th century. In the final stages of price revolutions there are greater imbalances, which create greater instabilities. "Prices surge and decline in swings of increasing amplitude. Markets of many kinds capital markets, commodity markets, labor markets become dangerously unstable. Production and productivity decline or stagnate, while prices continue to rise; together these trends create stagflation. Political instability increases, and with it comes social disorder, internal violence ( this weekend´┐Żs mall shootings) and international war. The cultural system becomes dangerously unstable; internal conflicts of value and identity grow more intense."[1]

What is missing is the precipitating event the rogue wave that nobody expects. It is this triggering event that creates the culminating crisis that wakes the markets up from their complacency. It could be a financial mishap, an international war, a new plague or the rise of a dictator. From wherever it springs forth it initiates the end game and brings about the final conclusion. Today's market complacency is about to be challenged. Following one of the axioms of military history, the generals are trained to fight the last war. In economic history, government planners and managers are taught to keep the last crisis from happening again. In the markets investors chase familiar price patterns and buy what has worked in the past. Trained to fight the last war, manage the last crisis, or buy the last bull market, they discover the world and the markets have changed. The next crisis is always different. It is a new war, a different bull market, or a something no one expects. That is why history rhymes more than repeats.

Today's Markets

Stock markets turned in a mixed performance on Monday. The Dow lost 4.88 points to close at 10,791.13. It had been locked in a narrow trading range all day. The Nasdaq edged up 6.25 points, to 2082.91, and the S&P 500 notched a 0.84 point gain to close at 1,206.14.

The markets fretted over subpoenas issued by New York's State Attorney General Elliott Spitzer and the SEC to AIG. For Wall Street it was the continuation of an existing scandal rather than its end.

In other markets, the dollar fell against the Japanese yen on reports of higher than expected Japanese trade surpluses. Gold futures rallied on weakness in the dollar rising $5.30 to $427.30. Oil markets also reversed with crude oil prices advancing $.28 to close at $47.44.

Bond prices posted slender gains with the benchmark 10-year note adding 2/32nds with the yield slipping a notch to 4.09 percent.

There was no significant economic data on Monday. All eyes this week will be on Mr. Greenspan's testimony to Congress.

[1] The Great Wave, by David Hackett Fischer, p. 248
chart courtesy: BCA Research

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© 2005 James Puplava

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