The Old Serpent of Inflation

He is still on the prowl, seeking who he may devour.

I read today an article by Stephen Roach of Morgan Stanley entitled, "The New Inflation." The basic premise of his article is that there are no mathematical constants with which to predict inflation. The rules have changed. He also points out that the current Fed chairman admits that we are in uncharted territories and that the Fed cannot see bubbles in time to stop them from growing out of hand. The old methods of fighting inflation no longer work.

Maybe they should try Austrian economics. Inflation is easily defined and controlled because inflation is the increase in the supply of money. The Federal Reserve has been increasing the money supply for several years now in ways easily seen and in ways not so easily seen.

The most open way that the Fed increases the money supply is by buying government bonds that the banks hold. This gives the banks more cash to lend and spend.

The Feds also lower the reserve requirements of the member banks. In 1863, with the passage of the National Bank Act, banks were given the opportunity to join a national organization to facilitate in the transfer of notes between member banks. In return, member banks were required to maintain reserve requirements at 25% of notes and deposits.

Today, thanks to loose Fed policy, banks' reserve requirements are below 2%. So for every $100 on deposit, a bank is required to have less than $2 held in reserve. This is not exactly the most secure position to be in; especially if several people decide that they need some or all of their money.

The effect of this loose reserve policy is an increase in the supply of money available for lending. Banks make money by lending their deposits at a higher rate than what they are currently paying, so the motivation for lending those freed up reserves is great.

Now it is true that we have not seen the effects of inflation trickling down through the system as we have in past years, but make no mistake, it is there. A couple of reasons exist for this slowing of the trickle down effect. First of all, the way that the government calculates the inflation rate hides the true inflation rate. As I've written about before, the adjustments and percentages used in the total calculation hides the true inflation rate. This allows the government to pay lower cost of living increases in their entitlement payments.

The second factor is simply an economic one. People like you and I are shoppers. We are always looking for a deal. We are price competitive. When local goods increase in price due to monetary inflation or supply shocks, like the current fuel situation, we will look elsewhere for better prices. Because of an expanding global economy, we have more choices today than ever before. You may have noticed that we hear very little of the "Buy American" program that used to be advertised on TV. That's because the ordinary consumer cannot afford American made products due to price inflation.

Of course, the results of our continually shopping elsewhere for our goods have a downside. Jobs are lost. Companies move production overseas to low labor countries. Our country runs a huge account deficit as we import far more goods than we export.

How bad is inflation? Well since inflation is the increase in the supply of money, let's look at some historical numbers. In January of 1959, the M3 or total measure of money stood at $292 Billion. As of September of this year, M3 stood at $9,958.2 Billion, increase of 3,300 percent.

On a related note, with the price of gold coming off of recent highs, I have read comments that suggest maybe gold is due for a correction in price. Well, dear reader, we cannot predict short-term prices, but we can get an idea of longer-term trends. If we take the high point of gold in 1981 at around $850 per ounce and we plug that number into any of the handy inflation calculators out on the Internet, we arrive at a projected current price of $1950. That number is based on government inflation numbers since 1981. Based on the numbers above, the real price could be much higher.

In light of these facts, folks, I would make sure that part of my investment portfolio contained gold, gold stocks, or gold funds. In my account, the value of my gold stock holdings has increased 162% since 2000, and that is after annual rebalancing to maintain my gold holdings at 10% of my portfolio.