The Inflation Tipping Point (Part Two of Four)
[Continuing from Part One…]
Turning now to the debate, the arguments of the deflationists have generally focused on the credit (or asset) definition of deflation. As long as credit is contracting, so the thinking goes, it matters not whether the central bank is growing the narrow money supply. Banks will simply sit on so-called “excess” reserves indefinitely as the credit contraction runs its course, which is probably going to be a period of years. As such, central bank money creation merely stabilizes the financial system; it does not transmit into fresh credit creation or economic activity and, therefore, does not necessarily contribute materially to commodity or consumer price inflation down the road.
US narrow money (M0) growth exploded in 2008-09
Certainly this seems an accurate description of what happened in 2008 and 2009. Credit markets collapsed; banks stopped lending; the Federal Reserve and other central banks created huge amounts of narrow money; yet while financial systems stabilized, this money did not flow into fresh credit creation, economic activity or consumer prices.
The inflationists, it would seem, were wrong, at least for a while. But to be fair, many of the inflationists focused primarily on monetary inflation, which has indeed been substantial, as pointed out above. In some cases the inflationists did predict a rapid or even simultaneous transmission from money creation into credit creation and along to commodity and consumer price inflation. Events in 2008-09 have shown this view to be false. But economic history as well as contemporary developments demonstrate that there is not a stable relationship over time between monetary inflation, credit inflation and commodity or consumer price inflation.
Mainstream, neo-Keynesian economics tends to place little value on monetary analysis for exactly this reason, that the link between money growth and consumer price inflation is impossible to model with reasonable accuracy and, as such, cannot usefully inform central bank monetary policy decision-making, focused as it supposedly is on maintaining a stable level of consumer prices. But just because something is difficult to model does not mean that it does not exist. After all, it is impossible to model precisely the “tipping point” behavior of people in a crowded theatre as smoke accumulates or, alternatively, that of investors, businesses and households amidst growing evidence of rising prices. But would anyone deny that these phenomena are real and that they can pose large if unpredictable risks?
Thinking along these lines, we believe there is now ample evidence that, over the course of 2010, there was a transition from credit deflation to inflation and that this has been transmitted almost instantaneously into commodity and consumer price inflation. As such, there is a growing risk of reaching a tipping point beyond which rising inflation expectations will fundamentally alter economic calculation and action from the largest global businesses down to the smallest households, with damaging economic consequences.
US broad money (M2) growth bounced sharply in mid-2010
Turning to credit developments, measures of broad money growth decelerated sharply in 2008-09 but this trend reversed by mid-2010. M2 growth fell to only 1% y/y in early 2010 but has since picked up to around 4.5%. Also around this time, US commercial bank lending stabilized and, in more recent months, has increased slightly. Credit deflation has reversed into inflation.
To be continued in Part Three of Four…
[Editor’s Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]