For years I have been expecting a surge in inflation. After all, how is it possible that the Fed can be creating so much new high-powered money without a jump in prices? Surely those who are familiar with the quantity theory of money share my puzzlement over the relatively stable Consumer Price Index (CPI).
In trying to understand the absence of rising prices I have thought a lot about fiat money and the process by which it enters into circulation. After a lot of searching and racking my brain I think I’ve found the inflation.
Low CPI inflation is in part a consequence of our broken banking system, as detailed in the January 22 blog. Because banks are reluctant to make loans, the rate of growth in high-powered money has greatly exceeded the growth rate in M-1.
But despite our broken banking system, M-1 is still growing pretty darn fast. For the six months ended December 31 M-1 has been growing at an annual rate of 10 percent, which compares to an annual CPI inflation rate of only about 1.5 percent. So, where is the money going? Where is the inflation?
Recall that the CPI measures inflation in the prices of consumer goods—capital goods are not included. If the price of an existing factory doubles, that doesn’t show up anywhere in the CPI. Nor do rising stock and bond prices. And that is where the inflation has occurred, as will be described below.
Perhaps it is useful to visualize an island economy where there are two goods, a consumption good (fish) and a capital good (fishing net). In the absence of fiat money there would arise some equilibrium price of a net in terms of fish—it might be 20 fish per net. If a net is expected to catch, say, 30 fish during its five-year economic life, an investor might reasonably be willing to give up 20 fish today in exchange for one. Of course, no rational investor would be willing to give up 32 fish now in exchange for a net that is only going to harvest 30 fish in the future—in that case the price of capital is simply too high.
Continuing with the illustration, let’s now suppose that fiat currency and a central bank emerge on the island. The central bank prints up money at a rate it deems to be appropriate. In order to get the new money into circulation the island’s central bank needs to buy something—it can buy fish and/or nets. Obviously, the terms of trade between fish and nets will be affected by the central bank’s decision as to which it buys. If the central bank is determined to rapidly print new money and introduce it into the economy entirely by purchasing nets, then initially the price of nets (capital goods) will soar relative to fish (consumption goods). Depending upon how feverishly the central bank is printing the money and buying up nets it becomes entirely possible that the fiat-currency price of a net will be 40 times the fiat currency price of a fish, even when the net is only capable of catching 30 fish over its economic life. The central bank in this example is not particularly worried about making a smart investment—its only goal is to get money out there, and fast!
Presently the Federal Reserve is introducing new money at a rate of $75 billion per month. The money enters the economy through open market operations where the Fed purchases government bonds and mortgage backed securities from hedge funds, mutual funds, investment banks and so forth. Obviously an initial impact may be to enrich the sellers of the securities the Fed is buying up. But more significantly for the economy as a whole the affect is to drive up bond prices well beyond what would otherwise make sense.
So that’s why bond prices are so high and interest rates are so low. However, the story doesn’t end there. The Fed’s intrusion into the market with a flood of fiat money has also impacted the stock market. Of course, the Fed doesn’t print up money to buy common stocks. So why have stock prices inflated? I believe this is easily understood when we consider who is selling all those bonds to the Fed.
Large financial institutions, hedge funds, and well-heeled investors who own bonds are rewarded when the Fed prints up new fiat money and buys some of their bonds for ballooned-up prices. But upon selling their bonds to the Fed the financial institution now finds itself invested in cash—an undesirable investment in a world where cash is being enthusiastically created by the central bank. Where do large investors then go in search for a better return? The answer is to stocks, and thus we see inflation appear in stock prices as well.
Have we reached the point where the price of capital goods exceeds the value of the future earnings the capital will be able to produce? (Is the fishing net now selling for 40 fish when it is only capable of catching 30 over its useful life?) Certainly the operation of the central bank the past several years has pushed us in that direction. To cite one piece of evidence, The Wall Street Journal reported a P/E ratio of 86 for the Russell 2000 as of January 17, 2014 (http://online.wsj.com/mdc/public/page/2_3021-peyield.html). So, this is where all the money is going, and where the inflation has first surfaced.
Ultimately markets converge towards rationality, and the relative prices of consumer goods and capital goods will make sense. This might happen with falling security prices or with rising prices for consumer goods. With all the new money sloshing around, I’m still expecting the latter.