Predictably, Inflation is on the March


#1

Predictably, Inflation is on the March.
Sept 19, 2018

Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. … A steady rate of monetary growth at a moderate level can provide a framework under which a country can have little inflation and much growth.
-Milton Friedman

Since the founding of the Federal Reserve in the United States, there has been roughly five periods with price deflation as measured by Consumer Price Index (CPI). The bias has been overwhelmingly price inflation.

Inflation, as measured by the CPI, is not actually the true rate of inflation for at least two reasons. Firstly, the CPI - which measures consumer prices - is an approximation of ‘price inflation’. When many people think of inflation today they are actually thinking of price inflation. This is why the CPI may come to mind as it is a measure of what people actually pay for a basket of goods and services. Secondly, the term ‘inflation’ has shifted over time. Using earlier definitions of inflation that pre-date Keynesianism, we know that according to Austrian school of economics, inflation was defined as a monetary event. That is, inflation is an increase in the money supply (…often causing an increase in prices). That is, there may be times when the CPI is increasing while the money supply is decreasing or vice-versa. In general however, the money supply and consumer prices are highly correlated.

For those of you who are now confused, think of increasing consumer or producer prices as ‘price inflation’ and think of inflation (or as some may refer to it ‘monetary inflation’) as an increase in the money supply.

According to the Bureau of Labour Statistics, the CPI recently increased to the highest rate in roughly 8 years. At the time of publishing this article, the annualized CPI monthly increase is 2.7% down from 2.9%. Barring a black swan event, I suspect this will continue for some time.

What Drives this Inflation?
To answer this question, we should first understand the definition of money. Money is often defined using different metrics. These are known as M1, M2, M3 and so-on. The important thing to understand is that M1 is the narrowest definition of money and is the most liquid. For example, currency held in someone’s wallet would be considered M1. M2 and M3 encompass increasingly broader financial instruments that can quickly be converted to money but strictly speaking, are not as liquid. For example, M2 and M3 would include money market funds and repurchase agreements which are rapidly maturing debts.

When observing a long-term change in money supply, we note that the year-to-year increases in all the definitions of money have stayed above 0% for most of that time with brief interludes during the 2008 great recession. This implies that the money supply has almost consistently increased.

pasted%20image%202
pasted%20image%201
pasted%20image%200

So What’s Driving Price Inflation this Time?
Estimates of Q2 2018 growth are 4.1% which is an incredibly fast increase rate given recent GDP growth history. Unemployment has also fallen a great deal during this expansion. Naturally these factors are manifesting in the measures of CPI and PPI despite a relatively tame increases in the definitions of money (M1-M3). What is also a factor is confidence. Confidence that money spent now is a good investment because prices are rising which further spurs velocity. In fact what is clear from the 2008 financial crisis is that it was a sudden decrease in confidence that the banking system was solvent that collapsed money velocity. Given that inflation is on the rise, will inflation hedges begin to outperform? Not exactly. Gold for example is in a downtrend versus US dollars. This is because the US dollar has strengthened due to economic growth and interest rates hikes that the Federal Reserve is making as a result.

Bitcoin as Digital Gold
In a previous article, I discussed how Bitcoin had the properties of digital gold. Part of the reason why Bitcoin is replacing gold is that it has become an important investment alternative. The bearish case for gold now lists Bitcoin and alternate cryptocurrencies as its competition for investors seeking an alternative to dollar exposure.

Anecdotally, in 2017 there was an influx of gold bulls attending Bitcoin 101 events at DCTRL (our Bitcoin community space in Vancouver) when the Bitcoin price surpassed an ounce of gold. More generally I can point to many gold resellers including Kitco.com, Goldmoney.com and others that now allow payment in Bitcoin.

Don’t get me wrong, I believe the price of gold could easily be revalued to $10,000 overnight if IMF one day announces a new currency paradigm based on Gold – possibly as a way to compete with Bitcoin. However, meanwhile Bitcoin is increasingly the new kid on the block attracting a lot of hype and with its increasing mainstream appeal it is nipping at gold demand.

Stable High Powered Money
High powered money, often referred to as monetary base or M0 / M1 depending on what central bank you are dealing with should increase at a stable rate. In the digital realm, Bitcoin provides the asset foundation upon which money systems can be built. This expanding universe includes country-specific cryptocurrencies like the inevitable ‘Fed Coin’ and the emerging price-stable currencies. Bitcoin’s gold-like properties may make it a disincentive to spend, but it permits the creation of new instruments that, as Friedman explains, allow for “a steady rate of monetary growth at a moderate level [which] can provide a framework under which a country can have little inflation and much growth”


#2

Wonderful post @DavidG. I see your point and I stand (partially) corrected.