The hunt for inflation leads to a dead end

Most investors want to know if the near future will be inflationary or deflationary, as both are investment and business game changers.

Cable pundits and investment newsletters are polarized in their opinions. The common theme among hyperinflation promoters is that the Federal Reserve Bank’s numerous trillion-dollar easings, which have unequivocally resulted in a 30 percent increase in the U.S. monetary base since 2008, will soon result in inflation. And, as the Fed explained, runaway money growth directly leads to inflation.

Yet, inflation devotees can’t find inflation evidence in the U.S. for the past four years. Outside the U.S., two major high growth countries (India and China) have seen meaningful inflation after 2008 but are now facing declining producer price pressures (excluding food prices).

And so goes the hunt for inflation... it’s a dead end.

What investors know about inflation is largely experiential. Those 50 years and older were schooled in the 1970’s inflation era when Fed Chairman Paul Volcker fought inflation by raising interest rates. His battle was to restrain expansion of the monetary base, the culprit.

The searing 1970’s experience is now seemingly at odds with the current environment r of no inflation, despite the U.S. monetarym base’s aggressive growth. fi Before concluding that the monetarist formula connecting money supply and inflation is woefully flawed, it’s best to firstf understand how the theory is supposed p to work.

Monetarists would say that a flat or recessionary U.S. economy can be jumpstarted by money expansion by the Fed, most effectively done by the Fed’s intervention that lowers bank reserve requirements and lowers a bank’s cost of borrowing. The Fed’s goal is to spur bank lending.

Under fractional reserve banking, an initial deposit at a U.S. bank is used to make loans — the loans result in a new deposit at another bank — which another bank loans etc. Through this virtual cycle, the money supply increases multiple times on the back of the initial deposit.

The Fed can also contract economic growth and/or reign in inflation by raising bank reserve requirements and/or raising bank costs of borrowing.

This monetarist tool kit was used by prior Fed chairmen Mr. Volcker (to end inflation) and Alan Greenspan (to generate growth). So, why then has the current runaway expansion in the monetary base under Fed Chairman Ben Bernanke not produced inflation?

Here are some explanations.

First, even a greatly increased money supply does not create inflation IF the velocity of money (how fast the money is turned) significantly slows. Money slows when the banks (even though having sufficient reserves) do not make loans or there is hoarding of cash. Though a lot of money is there, it just sits.

As to the current situation, there has been such a large drop in money’s velocity that there is no inflation... in fact, no loan growth. Money velocity is not easily changed by the Fed, as it is very much a reinforcing behavior. For instance, if the perception of the borrower or the person holding cash is that prices of assets will be cheaper in the near future, then they defer expenditures to a later time. This behavior en masse spreads and lowers velocity. The Fed has tried to use money expansion to offset deflationary effects of this decrease in money’s velocity.

Second, since 2007, there has been a huge contraction of international credit (some $3 trillion) — not from traditional banks but from within the “shadow banking” sector.

“Shadow banking” is all forms of credit creation outside of traditional banks. By 2007, credit in this sector exceeded all credit created through traditional banks. It includes collateralized mortgage pools; money market mutual funds, repos and, importantly, it includes rehypothecated hedge fund assets.

For instance, most hedge funds can offer client LLC assets as collateral to third party lenders which reoffer the same collateral and it starts a long chain of collateralized loans all using the original asset as collateral. Yes, a multiplier somewhat similar to fractional reserve banking — it just needs good collateral to start the chain of successive loans.

But, importantly, rehypothecation and all other “shadow banking” are not controlled by central bankers, only by market forces.

So the central banks are dealing with more than the problem of sovereign debt, they also face the strong deflationary forces within the “shadow banking” system and caused by lower velocity of money. And their tool kit was not designed to fix “shadow banking” contractions.

That, in my very humble opinion, is why there is currently no inflation. And the complexity of the banking system is such that most “experts” don’t understand or they are “selling” their forecast. My perspective is that the future is just not knowable. That is not to say that inflation will not ultimately emerge, but just not now.

What is an investor to do? A fully diversified portfolio with allocations to alternative assets might serve you best. As to the business and homeowner, locking in low loan rates still makes sense.

Talk to your current adviser as to the suitability of these ideas, talk to several advisers for breadth of opinion, and seek specialists for counsel in alternative asset classes. ¦

— Jeannette Showalter, CFA is a commodities broker with Worldwide Futures Systems, 571- 8896. For midweek commentaries, write to showalter@wwfsystems.com.