Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 5th July 2009.

Inflation expectations and the bond market

In 2006, 2007 and 2008, rising inflation expectations during the first half of the year prompted a sell-off in US Treasury Bonds. And in each case inflation expectations peaked in June, leading to an intermediate-term bottom in the T-Bond market at that time. Interestingly, but not surprisingly from our perspective, this year has followed a similar pattern to date. In particular, the following Fullermoney.com chart of the Expected CPI (the yield on the 10-year T-Note minus the yield on the 10-year inflation-protected T-Note) clearly illustrates the plunge in inflation expectations that occurred during the second half of last year and their revival during the first half of this year.

There is sometimes a big difference between reality and the market's perception of reality, especially when it comes to inflation/deflation. At no time since 1933 has the US faced a high probability of deflation (in the true meaning of the term), and yet the financial markets periodically act as if deflation were occurring or about to occur. The second half of last year was a classic example in that the financial markets fretted over the prospect of deflation even while the rate of money-supply expansion was near an all-time high.

Markets always move into line with reality, eventually. In the interim, divergences between perception and reality will create investing opportunities.

It is likely, in our opinion, that inflation expectations will fall over the months ahead, and it is quite possible that at some point between now and year-end the markets will experience another of their periodic deflation scares*. If this proves to be the case then the second half of this year should be characterised by general strength in the US$ and US Treasury Bonds, weakness in equities and industrial commodities, and a rising gold/commodity ratio.

*We define "deflation scare" as a time when fear of deflation dominates the financial landscape even though the rate of monetary inflation is high.

The link between money supply and purchasing power

Changes in the supply of credit do not have long-term effects on the purchasing power of money. For example, if Fred lends some of his money to Tom there will be an increase in the economy-wide supply of credit, but the economy-wide supply of money will remain the same (part of the money supply has simply changed hands). Therefore, the purchasing power of money will be unaffected. Furthermore, when Tom either repays or defaults on his loan to Fred there will, again, be no change in the economy-wide supply of money and, therefore, no inflationary or deflationary effects (Fred suffers a loss in the case of a default, but the money that was loaned to Tom remains within the economy).

On the other hand, if Tom chooses to borrow from a bank rather than from Fred then the resultant increase in the economy-wide supply of credit will have inflationary consequences as long as the bank does what banks typically do these days and makes the loan using newly-created money. It is important to understand, though, that any inflationary effects are due to the increase in the money supply and not the associated increase in credit supply. To put it another way, an increase in the supply of credit can only be inflationary to the extent that it brings about an increase in the money supply. By the same token, a decrease in the credit supply cannot possibly be deflationary unless it brings about a decrease in the money supply.

We know by logical deduction that substantial changes in the money supply MUST ultimately have an inverse effect on purchasing power (higher money supply leads to higher prices, etc.), but due to the non-uniformity of the whole process and the large time delays between cause and effect it is often difficult to 'see' the link. The relationship between money supply and money purchasing-power certainly doesn't conform to the simplistic Quantity Theory of Money. In other words, it is difficult to use data to persuasively demonstrate the relationship between money-supply changes and price changes.

The difficulty or impossibility of using data to prove, or even to demonstrate, a concept is a common issue in economics. This is because economics is a logical science dealing with human action, not an empirical one dealing with laws of nature. In this particular case, however, data can be used to demonstrate the theory by using long-term moving averages to eliminate short- and medium-term fluctuations. For example, the following chart uses 10-year moving averages to reveal the strong positive correlation that exists over the very long-term between the rates of change in the money supply and the CPI. Hats off to the team at http://www.nowandfutures.com/ for preparing this excellent chart.

Notes:

1. The most relevant lines on this chart are the black line (the CPI as calculated by www.shadowstats.com) and the blue line (M2 money supply).

2. Even an honest attempt to calculate a single number that represents the economy-wide purchasing power of a currency will fail because no such number exists, but an honest attempt will potentially capture the general purchasing-power trend.

The above chart's message can be summarised thusly: Through booms, busts (including the Great Depression) and everything in between, changes in the US dollar's purchasing power have been determined by changes in the money-supply growth rate.

The more important inflationary effects

Most people, including most central bankers, believe that monetary inflation isn't a problem until/unless it causes a sizeable increase in the general price level. But as explained in previous TSI commentaries, if monetary inflation did nothing other than reduce the currency's purchasing power it wouldn't be anywhere near as troublesome as it actually is.

To understand why monetary inflation is a much bigger problem than commonly believed, just take a look around. The great worldwide boom of 2003-2007 was, at its heart, an effect of inflation. As was the financial collapse of 2008. As is the depression that began about 18 months ago and looks set to continue for many years. In addition, the aggressive power grabs being carried out by the US government and other governments around the world are being 'financed' by monetary inflation. If not for the ability to steal the purchasing power of others by creating money out of nothing, governments would have to remain small and banks would be restricted to doing what they were originally established to do: providing secure storage for savings and acting as intermediaries between savers and borrowers.

In a nutshell, monetary inflation isn't a problem because it leads to a broad-based increase in prices; it is a problem because it a) distorts the price signals upon which the market economy relies, b) temporarily makes it seem as if the quantity of real savings is higher than is actually the case (thus leading to mal-investment on a grand scale and the destruction of real savings), c) facilitates the re-distribution of wealth to the detriment of the overall economy and the living standards of most people, and d) allows the government to become far more powerful than it should be.

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