When the money supply expands, prices tend to rise. They certainly don’t rise uniformly, but as long as the velocity of money is near constant, the average price increase should roughly match the expansion of the money supply.

Recently (except for the recent limit-down day), commodity prices have been on a tear, but the base money supply—controlled for excess reserves—hasn’t moved much. In addition, the core CPI hasn’t moved by nearly as much as the base commodities. This could be explained by shrinking profit margins. However, in the meantime, corporate profits are up.

Let’s say that there was a bad wheat harvest. It is reasonable to expect the price of wheat to rise. It seems reasonable that the price of bread should also rise. Money you spend on bread, however, must come from somewhere else. This causes demand in some other good to drop off. It’s reasonable for falling demand to cause that other good to become cheaper. Without a commensurate increase in pay, it is difficult to have an input cost for a raw material such as wheat lead to a general price increase.

This is not to say it is impossible. If there were only two goods in our economy, guns and butter, they could both rise in price while the money supply stayed the same. In this case, a fall in total demand takes place. Since we measure the quality of life by how much butter and guns we consume, this general price increase without monetary inflation must result in a decrease in the overall standard of living. Again, this decrease need not take place in a uniform manner. Corporate profits can be up, provided enough people take a pay cut or lose their job.

Boring is good.

Once again, this is the graph of excess reserves and the base money supply. While the base money supply has exploded, excess reserves has kept pace. The last time I plotted this out, it looked like the beginning of a possible divergence to the upside. We’re back to boring, which means we aren’t at the point of burning dollars for warmth (sadly, I can’t say much about the predictive qualities of this graph. You probably knew we weren’t currently experiencing hyperinflation).

I just read a paper by Professor (Emeritus) Herbert Grubel about the costs, benefits, and likelihood of success in using inflation as a means of reducing the US debt burden. It discussed the significant excess reserves being held by banks as well as the technical capabilities of the Fed for keeping those excess reserves from causing the M1 to explode. It made me think of this graph. Honestly, I was kind of expecting a little more of an uptick in the green line.

(source: St. Louis Fed: FRED Graph)

Hmmm….

I’ve used this graph for a while as a reason to dismiss concerns about big inflation (or likened it to a coiled spring, depending on the mood I’ve been in). So when I read some alarmist headlines about growth in M2, I regenerated this image to see if there was any reason for concern. For the first time, I am not comfortable with the outcome. It is still early as far as the data is concerned, but the green line seems to be diverging from the red line. If this continues, and M2 growth accelerates, there could be genuine reasons to be concerned about big inflation.

Now, having provided an alarmist paragraph myself, I do feel obligated to point out that this may be but a temporary win for inflation. Inflation currently is winning. However, there are significant deflationary pressures (default, always default). Commercial real estate delinquencies are still growing, and there’s some real concern about state finances. Since debt is the most important aspect of the money supply, a turn for the worse in the bond market would make the growth in the base-minus-reserves meaningless.

(via research.stlouisfed.org)

Screw it, let’s panic.

We’ve been waiting for a move in the green line substantially up or down from the trend. That would be a nice indicator (two months delayed) of an inflationary explosion or deflationary collapse. From a strictly monetary perspective, neither option seems to be winning right now.

If we examine prices, it is possible that money has moved out of certain asset classes and into other asset classes that we, as a society, are more price sensitive to. Wheat prices have spiked recently, though they are still down significantly from their peak in 2008. This could be due to export restrictions in Russia, and not money movements. Coffee prices are way up, though this too might be due to supply issues. In general, food and beverages seem to be increasing in price. These are the prices we care about on a day-to-day basis. Despite this, CPI growth is rather muted. Part of that is due to the fact that the CPI is weighted in interesting ways and then built up out of statistical voodoo. Part of it is due to the stickiness of consumer end prices.

The Fed seems to be embarking on a journey of new and unproven policy decisions. However, those calling for hyperinflation may still be too early on the call. Prices thus far have been more sensitive to politics, trade, and normal supply and demand issues than they have been to actions by the Fed. And the Fed’s journey may not be into territory all that unexplored. QE2 seems to be more of a continuation of current policies than something new. The Fed’s POMO activity is a weekly occurrence. They are now the number 2 holder of US treasuries after China. They surpassed Japan today.

It isn’t that I don’t believe this will end badly. I certainly think that’s the case. However, when it ends is a huge guess. We can panic now, if we like, but it might take some serious determination to maintain a level of panic into the end. It could be days, months, or even years in the future.

(source: St. Louis Fed: FRED Graph)

Still no reason to panic?

I starting looking at this graph to help convince myself (and a few others) that hyperinflation wasn’t going to be the immediate impact of the exploding monetary base. In the passing year, bread still isn’t a thousand dollars a loaf, so it is possible that we haven’t yet had hyperinflation.

At this point, I’m a little surprised these two have managed to track each other so perfectly. As before, the explosion (and wiggly increase and contraction) in the base money supply is entirely explained by the excess reserves plugging the gaping holes on banks’ balance sheets. Neither inflation nor deflation has emerged as a true victor here. All of this is merely a chart of the Federal Reserve’s (successful, so far) attempt to prop up the banks.

Do you know what would be really impressive? If that green line manages to keep on its current trend through the next crisis. Whether that crisis is crunching state budgets, bank failures in Europe, stock market collapse in the US, or any of the other big potential problems, if those red and blue lines manage to track one another, that would be impressive. There’s only a single small bump in the green line during all of that chaos. And do you know what would be scary? If that green line deviates too far from the trend. That means the Fed has lost control of monetary policy. Unfortunately, sometimes authority and effort aren’t enough to determine outcome.

(source: St. Louis Fed: FRED Graph)