INFLATION

Arthur Laffer predicts inflation.  It's all about the money supply.

'About eight months ago, starting in early September 2008, the Bernanke Fed did an abrupt about-face and radically increased the monetary base -- which is comprised of currency in circulation, member bank reserves held at the Fed, and vault cash -- by a little less than $1 trillion. The Fed controls the monetary base 100% and does so by purchasing and selling assets in the open market. By such a radical move, the Fed signaled a 180-degree shift in its focus from an anti-inflation position to an anti-deflation position. The percentage increase in the monetary base is the largest increase in the past 50 years by a factor of 10 (see chart nearby). It is so far outside the realm of our prior experiential base that historical comparisons are rendered difficult if not meaningless. The currency-in-circulation component of the monetary base -- which prior to the expansion had comprised 95% of the monetary base -- has risen by a little less than 10%, while bank reserves have increased almost 20-fold. Now the currency-in-circulation component of the monetary base is a smidgen less than 50% of the monetary base. Yikes! [...] It's difficult to estimate the magnitude of the inflationary and interest-rate consequences of the Fed's actions because, frankly, we haven't ever seen anything like this in the U.S. To date what's happened is potentially far more inflationary than were the monetary policies of the 1970s, when the prime interest rate peaked at 21.5% and inflation peaked in the low double digits.'

If the chart above is a true indication I don't see how we're going to avoid inflation.  According to Mr. Laffer the big jump in the money supply is from a huge increase in bank reserves which he says are "excess reserves."   That means those reserves won't languish in bank vaults but will hit the street as loans, increasing the currency-in-circulation.  The impact is likely to be huge. Update: Russia may unload some U.S. Treasuries from its reserves and replace them with International Monetary Fund bonds. Alexei Ulyukayev, first deputy chairman of Russia’s central bank, said some reserves may be moved from Treasuries into IMF debt, reiterating comments made last month by Finance Minister Alexei Kudrin. Ulyukayev’s remarks were confirmed by a Bank Rossii official who declined to be named, citing bank policy. Treasuries fell, pushing 10-year yields toward the highest level in seven months, in response to Ulyukayev’s statement. The dollar fell against the euro on speculation that Russia will reduce its holdings of U.S. debt. The government is going to pay higher interest rates in order to finance Obama's unprecedented yet planned massive deficit spending.

Comments

[TX CHL Instructor]

There is more to inflation than the 'raw' money supply. Deflation is a very powerful positive-feedback loop, in which money tends to leave the banking system (the "mattress money" phenomenon). There are several reasons for this, but the most important is a (reasonable) loss of confidence in the banking system.

Because we are running on a 9:1 fractional reserve system (where money is actually based on debt, and not on value), every dollar that leaves the banking system actually reduces the money supply by nearly $100. Maybe even more, if you consider "money velocity" decrease caused by people putting off even necessary buying due to falling prices. So it will take a LOT of money-pumping to overcome the mattress money. It is noteworthy that the actual amount of currency (bills and coins) in circulation in 1931 was quite a bit more than in 1929.

If the government does manage to pump that much money into the system to break the cycle of deflation, then there will be this other problem. Since money isn't based on anything of value, the only remaining characteristic of importance regarding money is that it is a form of information. Since information spreads a bit faster now than it did in 1933 (Twitter, anyone?), when the mattress money returns to circulation, it will do so ALL AT ONCE. Think about that for a little while. You don't have to be a member of the tinfoil-hat brigade to be alarmed by that.

Unfortunately, the noise-to-signal ratio in the money-information is a bit high. After all, prices tend to move in different directions for different things. Gasoline may go up at the same time housing collapses, or vice versa. So it may be a bit tricky to track the real inflation/deflation, which is the ratio of the money supply (all components) to the total available value in the economy. By the time it's really clear that the bottom has been reached, if you have not already prepared, it will be way too late.

One thing that I expect just before the really big plunge is the "call of the sheep to the slaughter." That's when everybody is urged to get back into the stock market or various other financial investments, and all of the financial advisers are telling their customers that the worst is over. The government will be touting "Happy Days are Here Again!"

Word to the wise: A few months' supply of cash might allow you to make your mortgage payments during the bank holiday. The value of that cash will disappear, but the mortgage company will have to accept it unless the government changes the legal tender law (as you might expect, they would much rather have your house than your worthless money). Just be sure not to use paper money for anything other than repayment of dollar-denominated debt. A few month's supply of nonperishable food and potable water might be worth having, too.

Of course, predicting the future is tricky business, and I certainly could be wrong. Actually, I hope I am. Even with advance preparation, there are ways that things could go so bad that I won't be able to cope. It's still better to have and not need than need and not have.