Inflation and money supply

So far i have become acquainted with the Federal Funds Rate, bonds and foreign exchange. It’s time to look at two very important topics – inflation and money supply. This article looks at some of the implications of events taking place on inflation and money supply. The article presents (presumes) some important concepts and ideas that i thought would be interesting to extract as well as comment on. First, some important definitions from Wikipedia:

  • Inflation means a rise in the general level of prices of goods and services over time. Economists agree that high rates of inflation are caused by high rates of growth of the money supply
  • The money supply refers to the total amount of money held by the nonbank public at a point in time in an economy.
  • The terms fiat currency and fiat money relate to types of currency or money whose usefulness results, not from any intrinsic value or guarantee that it can be converted into gold or another currency, but only from a government’s order (fiat) that it must be accepted as a means of payment.
  • Money creation is the process by which money is produced or issued. There are two different ways to create money:
    • physically manufacturing a new monetary unit, such as paper currency or metal coins
    • loaning out a physical monetary unit multiple times through fractional-reserve lending

Now the article:

  • CPI [Consumer Price Index] is the only inflation measure many people ever focus on even though it is so heavily massaged it borders on fiction (reads: CPI is what they want you to believe inflation is)
  • hard money monetarists view all fiat currency as ultimately doomed stores of value – politicians and bureaucrats will always fall back on the printing press when times get tough and thereby erode the value of that currency. (Governments have the means to print money at will, see point 4 in this wiki entry)
  • In the US, M2 (cash, current account deposits, and short-term savings deposits) have dived, going from a growth of 12% last year to an 8% contraction (so far) this year. This doesn’t bode well for growth figures. (There is a correlation between M2 money supply and nominal GDP)
  • In addition to rocketing CPI, this is also a period of collapsing asset prices in large part generated by the backlash from that housing bubble. The question for markets is which set of price changes should it be responding to? Based on the unprecedented scale of asset price falls we think there is little doubt they will trump headline inflation numbers. (Higher CPI implies interest rates should be raised to curb inflation whereas falling housing or asset prices implies interest rates should be cut to encourage spending and economic growth)
  • With unemployment in the US rising it is difficult imagine wage increases gathering steam. Wage-pushing higher in response [to] price gains has always been the mechanism that imbeds higher inflation and makes it so hard to control. (Price/wage spiral is one of the causes of inflation)
  • Bernanke is a student of the Depression and most agree that credit contraction at the wrong time helped to create and prolong that disaster. Banks are so reluctant to lend right now that we can’t imagine Bernanke adding to the misery. He’s going to keep the lending lines open and there is little chance of a rate gain even in the face of high CPI numbers. (The Federal Reserve’s mission is to keep the economy afloat and avoid recession)
  • We expect continued heavy spending on infrastructure in many regions, and that they could be joined by the US itself post election. The US needs that spending anyway and infrastructure has been proven to be some of the most effective “make work” money. One of the secrets to China’s success has been its willingness, and lack of impediments, to huge funding of money on roads, power, and communications. (Infrastructure spending is an effective way of creating jobs and spurring the economy)
  • Infrastructure spending means “stuff” should to continue to be a winning sector, though maybe not next week or next month in terms of share prices. Commodity prices will continue to be historically strong, but it simply will take a better market environment for anyone to care. (Commodities will still be in high demand, i.e. prices should continue to rise in the long run, despite recent weakness)
  • If shrinking credit markets continue to be the focus, the Fed will continue to be accommodative even while true-market interest rates (the spread) stay relatively high. Back stopping stupid investment banks and trying to rescue homeowners will mean more debt expansion for the US government. That combined with loose monetary policy will keep the US Dollar relatively weak. That will be a boon for gold and silver. (The Fed resorts to injecting liquidity to help rescue banks in trouble and in doing so they devalue the dollar. The recent scramble for dollar may explain why the dollar has gone up at a time when money is being injected)


Here’s a recent update to inflation happening around the world. Further reading up on the monetary system available here.

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