Are We Being Fed-Winked?
According to the latest Personal Consumption Index, the Fed would have us believe that inflation in the last year to February 2008 averaged 2.7% while “core inflation” which excludes food and fuel costs rose at an annualized rate of 2.1%.
So what does it mean? If you believe the Fed, overall cost of living rose 2.7% and core even less. So why track “core” inflation? Good question. It basically means nothing unless you don’t drive a car, don’t heat a home and don’t use any products that must be transported by vehicles the require either. (Thanks to the recent bio fuels trend, food products are now used as fuel.) But the Fed uses it as one of their favorite inflation metrics.
Now let’s get some other perspectives on inflation. According to Thomas Winmill, manager of the Midas Fund, a top-performing gold and precious metal funds with a three-year average return of 41.6%, inflation is a much bigger problem than the Fed would have us believe. To get an idea how much, he believes we simply have to look upstream in the production process. Prices on intermediate goods or those that are half-way through production increased 8.8% in the year to February 2008. Prices on early-stage goods were up 24%.
Meanwhile, the price of crude oil, which is the raw material of a wide variety of petroleum-based fuel and consumer products, has jumped 65% over the same period. And speaking of gold, the standard backing of our currency until 1971, was is up 46% by the end of February from the year before. The Commodity Research Bureau Index (CRB) a basket of 17 different commodities from sugar to natural gas gained more than 32% during the same period.
That’s not all. Few would argue that a strong dollar is good for our economy and with the exception of U.S. multinationals that sell products overseas, a weak dollar is bad. But a falling dollar is also inflationary and since February 2002, the good old greenback has fallen more than 40% against a basket of six currencies. That means that the cost of imported costs have skyrocketed along with commodities, fuel, imported food and raw materials. It also means Americans now must pay an average of 40% more than they did six years ago whenever they travel abroad. Since February 2007, the dollar has lost 16% in value.
Pumping Up the Cash
On March 28, the St Louis Fed released the final edition of its financial data report that updated U.S. money supply figures. The unique standout in the report was the big jump in the last few months as the Fed struggled to prevent a credit meltdown.
Few would argue that the more money a country produces the less valuable it is. With that thought in mind, let’s look what has been happening with money supply. But first some brief explanations.
Figure 1 – Chart to February 2006 showing the size of money supply M1, M2 and M3 from 1959 through early 2006. In the 1960s, the M2 and M3 were roughly equal but by the final monthly Fed M3 report in February 2006, M3 was more than 53% larger than M2. Data – St. Louis Fed
M1 = Currency held by the public, plus travelers' checks, demand deposits, Negotiable Order of Withdrawal (NOW) accounts, Super NOW accounts, Automatic Transfer Service (ATS) accounts, and credit union share drafts.
M2 = M1 plus savings and small denomination time deposits, Money Market Deposit Accounts, money market mutual fund shares owned by individual investors.
M3 = M2 plus large time deposits (> $100,000), large denomination term repurchase agreements, shares in money market mutual funds owned by institutional investors, and certain Eurodollar deposits including of U.S. residents held by U.S. banks in foreign branches worldwide. The broadest measure of money supply, it was discontinued by the Fed in March 2006.
M1 is basically money in circulation in the U.S., M2 includes M1 plus individuals’ savings, money market deposits and mutual fund shares while M3 was the broadest measure and includes the other two plus a number of institutional financial instruments. So of the three, M3 represents the largest money supply metric and most accurately demonstrates what large investors such as institutions and banks are doing.
As we see from Figure 1, M2 and M3 were roughly equal in the 1960s but by 2006, M3 was more than one and a half times M2.
Figure 2 – Seventeen month chart of MZM showing the dramatic increase beginning 2008. For more detailed annualized figures, see table below. Chart – St. Louis Fed
MZM = Here is one more definition that has taken on new importance in the wake of the Fed’s M3 decision last year. Money of zero maturity is the broadest measure of the money supply now that M3 statistics have been discontinued. It is equal to M2 less time deposits, plus all money market funds and measures the supply of financial assets redeemable at par on demand. MZM has become a preferred money supply measure since it describes money readily available for spending and consumption. Basically it is all financial instruments excluding those that bear interest (like bonds, term deposits etc.) or that involve risk (like securities).
Here is the big story on MZM money supply. As of Fed chart in Figure 2, it has increased 17% in just 15 months. But of greater concern is the fact that now money supply (not including a host of financial instruments including mortgages and derivatives) is exploding at 37% a year up from 11% just seven months ago according to Table 2!
So is the situation with MZM unique? Take a look at Figure 3 showing M2 growth rates and note the same parabolic explosion since the beginning of the year. M2 is now growing at an annualized rate of 17.4% up from a rate of 5.2% in June 2007.
Table 2 – Table from the St. Louis Fed showing the rapidly increasing growth in money supply in the compound rates of change in the last six months hitting an incredible annualized growth rate of 36.8% on March 17. Table – St. Louis Fed
Figure 3 – This chart shows M2 growth with the latest annualized growth rate of 17% (see insert). Chart – St. Louis Fed
Money supply has a powerful impact on markets and the economy. So if M3 were the most useful of the three, why would the Fed discontinue it? Good question.
Let’s examine an explanation that makes far more sense than those put forward by the Fed. Here are comments made by Fed Governor Ben Bernanke in 2002, long before his most recent promotion that provide a valuable clue.
“Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” From a speech entitled Deflation: Making Sure "It" Doesn't Happen Here by Governor Ben S. Bernanke before the National Economists Club, Washington, D.C. November 21, 2002. Link - http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm
Boy, no truer words were spoken in the last line of his quote [italicized by me]! Based on the current account and budget deficits, the government has been very determined in generating higher spending as the gentlemen says, and as long as spending soars so will inflationary pressure.
Was Ben Bernanke, who promised a more transparent Fed, having second thoughts or was that simply his way of putting Congress at ease during his confirmation hearings? But looking at the situation in retrospect, is it any wonder why the Fed stopped publishing M3 data?
But getting back to the heart of the matter is the inflation threat a priority for the Fed is the agency gone into panic mode in an effort to prevent the bursting of asset bubbles?
Putting the Pieces Together
In the last year, commodity prices are up 32%, and prices on goods in early to midway through production are up 24% and 9% respectively. Gold is up 46%, and crude oil 65%, the dollar has depreciated 16% in the last year and the total measurable supply of money (MZM) has jumped 37% on an annualized basis.
Figure 4 – The price of a weak dollar policy – priced in gold the Dow Jones Industrial Average has fallen 73% since 1999 in real terms. Chart GenesisFT.com
Granted housing prices have fallen and that should be good for reducing inflation but is it? In an effort to prevent the volatility rising home prices caused, the Fed took them out of inflation calculations and instead used something called Owners Equivalent Rents. This metric estimates what a homeowner would have to pay for his or her home in rental if it was rented instead of owned. Unfortunately, as foreclosures skyrocket and home prices fall, it puts upward pressure on rents so is actually inflationary. But that is another story.
And what about the explosion in derivatives products over the last five years? In my opinion, derivatives are at the root of the credit problems we are suffering through today.
Derivatives are financially engineered instruments that act like money (credit) but have the same effect as increasing money supply. But because this market is relatively new and unregulated, it is not included in current money supply statistics. If it was, given the massive size of the market total money supply would be growing even more rapidly.
According to the latest Bank of International Settlements data, the total amount of over-the-counter derivative instruments outstanding topped $460 trillion as of June 2007 and that market was doubling in size every 2.5 years. Assuming the same rate of growth, this total will top $650 trillion by June 2008. That equals 50 times the current annual gross domestic product of the United States. But from an inflation standpoint, the amount of new money being created in new derivatives products amounts to 40% every year.
And the Fed would have us believe that the cost of living is up just 2.7% in the last year?
With a Fed funds rate currently at 2.25%, the overnight rate is below the published rate of inflation. According to traders, there is a 100% chance that the rate will drop to 2% at the very least at the next Federal Open Market Committee meeting. Are interest rates below the very lowest (and completely unrealistic) inflation estimate inflationary? You bet they are.
It is clear that even with the data the Fed does not want us to see, it is easy to see that there is a whole lot of inflation going on and the problem is accelerating if money supply is any indication. The Fed has not only put inflation concerns on the back burner, they appear to have thrown them out the window and are now using their rather formidable powers to create even more inflation.
The challenge is that we lose either way. If the economic slowdown is reversed, the inflation cure becomes a formidable problem very quickly. In the 1980s under Paul Volcker, it took pushing the Fed funds rate above 19% twice, a serious recession and the highest unemployment rates since the Great Depression to cure the problem. History tells us that once a bubble has begun to burst nothing can stop it. And the harder the Fed and government try, the worse they make the ultimate problem and eventual solution.
If the slowdown continues, our dollar will continue to drop and the cost of living will soar. We will fall back into the stagflation trap of the 1970s. At some point foreigners who provide credit by buying U.S. Treasuring and other U.S. dollar denominated assets will demand a higher return. No matter what the Fed does, interest rates will soar.
So how do you make money in this environment? First of all, take the standard inflation estimates like the Consumer Price Index (CPI), Personal Consumption Expenditures (PCE) and the PCE deflator and ignore them. They have been designed to make the problem look much tamer than it really is. After all, it’s an election year and we all know how vigorously the government and all their minions (including those at the Fed) do their best to make the economy look as rosy as possible heading into each election.
Second, it is essential to have some non-US dollar exposure (hedge). This can take the form of a gold or commodity investment or even some foreign stocks trading in other markets or as exchange traded funds (ETFs) or American Depository Receipts (ADRs) on U.S. exchanges.
Finally and perhaps most importantly, it is essential to have access to some sort of proven and reliable market timing system to get you into the market as soon as prudent to catch the rallies, brief as they may be if this bear market continues, and out in time to avoid the big drops.
Keeping a supply of tinned goods, fuel and other essentials might not be a bad idea either just in case prices get completely out of hand. 
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