Greetings,
On my latest post on Debtor's Prison, I have set out to answer the very simple question of "What kind of inflation can we expect if the monetary machine returns to 'normal'?". It's quite a simple premise, and one that I think most can see eye to eye on, no matter what side of the inflation/deflation debate you are on.

The basic assumption is that CPI is correlated with M2. This is certainly the case, in the past 50 years, the correlation coefficient between them is 0.97. Therefore, we can be safe in using M2 as a barometer of CPI.

As for the future "projections", we very simply assume that the M2 Money Multiplier (M2/M0) returns to "normal" in 18 months (the same amount of time it took it to deteriorate from 8.9 to 4.0). I also assume that M0 stays constant. This is a very safe assumtion since the asset side of the Fed Balance Sheet is now primarily composed of long-term assets that can't be easily disposed.

This allows me to extrapolate potential M2 levels to August 2011 (the end of the 18mo recovery period). Given the growth of M2, and using the correlation coefficient to CPI, we can easily derive the projected growth of CPI.

The conclusions of this EXTREMELY simple exercise are staggering:
If the M2 Money Multiplier returns to its "normal" level, and the CPI correlation continues to hold, then we would reach a CPI level of 21% in February 2011!

Please check out the article if you need further convincing. Such a simple exercise as this has very little space for bias, and I cordially invite you to vigorously debate the parameters and set up. I have provided all the XLS charts with all the data, and some MATLAB M-files for the dorks amongst you, which you can only download at the original post.

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http://www.debtorsprisonblog.org/journal/2010/3/18/what-kind-of-inflation-can-we-expect-if-the-monetary-machine.html

Greetings Fellow Inmates,

Today’s will be a pithy post that aims to estimate the amount of inflation we could expect if the monetary machine returns to “normal” functioning. This is the same great question Discipulus has been asking for months. It is a VERY central question to our discussions for the following reasons. We have postulated many times that Uncle Benny’s monetary adventures with his FedBS will result in great inflation down the line. More specifically, we have estimated that we will reach Super-Inflation levels, which we have defined at a CPI reading of 25%. There are a many reasons that lead us to believe that inflation will rise that dramatically over the next 3 years. To begin with, simple explosion in the size of the monetary base is reason enough to believe inflation will be great down the line. Why? Well, those TRILLIONS of dollars that have been pumped into the base of the economy (we’re not even talking about the trillions of dollars given as fiscal bailouts) through the increase in Excess Bank Reserves (EBR) on the FedBS are SITTING IDLE STILL. As the story goes, allegedly, once the banks start lending again and the economy fully recovers (such that there is both credit supply and demand), then we expect all that high-powered money in the form of EBR will “trickle down” to the economy and result in a growth in the broad monetary aggregates. Remember, the broad monetary aggregates, in this case M2, measure the total amount of “liquid” money in the economy at large, as gauged by the cumulative totals of a range of deposit classes.

As the traditional picture goes, each dollar in the monetary base gets lent through the fractional reserve banking system and then gets “multiplied” through the economy, and eventually results in about $10 total deposits in the banking system. In other words, each $1 of EBR is supposed to create roughly $10 in the economy at large. Normally, this, “multiplying” effect is measured by something called the Money Multiplier. Quite simply, all you do is divide M2 by M0 (or the monetary base, which includes EBR and cash in circulation) and you get the M2 Money Multiplier. Now, bear in mind that the Money Multiplier model has been discredited, but it doesn’t matter for this experiment if M0 leads M2 or the other way around. In other words, the “textbook” model says that banks turn around and lend the cash only AFTER Uncle Benny has created reserves in their account. Reality shows the opposite: banks lend as much as they want and THEN Uncle Benny creates the necessary reserves for them to meet their requirements.

Ultimately this distinction matters naught for now. All we will do is attempt to answer the question: What kind of CPI can we expect if we return to a normal M2 Money Multiplier? Perhaps we should backtrack a bit. Below is a chart of the M2 Money Multiplier from 2006 to today.


Notice that there was a very sharp drop following the Lehman bankruptcy. The reason for this is that M0 (the monetary base, EBR) absolutely exploded, while M2 barely grew at all as people’s “money” was being destroyed. All these EBR, this great increase in M0, is still sitting idle in the banks’ accounts, they are still refusing to lend (yeah, yeah, remember that?) Therefore, it is a very good question to ask, well, what happens when everything recovers (as all the talking heads everywhere are falling over themselves telling you it is so close they can smell it) and the banks lend again and we return to a “normal” level of an M2 Money Multiplier? Presumably, all those EBR will trickle out and M2 will rise tremendously as it “catches up” with M0.

Why do we care about what happens with M2? Well, to quote MiltonKeynesSmith, “inflation is always and everywhere a monetary phenomenon”. In other words, what happens with the AMOUNT OF MONEY, M2, is primarily responsible for any increase in inflation. We can clearly see that this is the case in the following chart. All the data come courtesy of Uncle Benny and we have aggregated all the relevant data into an XLS file, for your convenience.



Wow, it is clearly evident that M2 and CPI are in fact related. Basing ourselves on this evidentiary support, we can proceed to make yet another very simple model that will illustrate a few key things. For this exercise we shall use our Trusty Abacus # 3 (TA3). For those of you that have a similar abacus, we will also begin posting all our M-Files so that you can dissect, check for accuracy and modify until your heart’s content! Here is the M-file for all the following experiment.

First, to corroborate the evidence that bases our assumption that projecting future M2 should be a good indication of future CPI, we calculated the correlation coefficient between M2 and CPI, using data going back to 1960. Clearly, when calculating correlation coefficients for such fundamental macroeconomic variables, using a longer time-frame gives you a more robust estimate. What we found was that for the past 50 years, CPI and M2 are 97% correlated! So, we proceed safely.

The premise of our model is very simple. We assume that M0 stays at current levels, meaning that Uncle Benny does not extend QE, and no more monetary bailouts are undertaken. There is a fat chance of this happening and in fact we have prognosticated that Uncle Benny will greatly ramp up QE once people start to refuse to buy Treasuries. But as always, we like to counter our own biases for the sake of the model. It is also a very safe assumption since, as we have said many times, Uncle Benny is stuck with all those long term assets on the Asset side of the FedBS, so M0 (the liability side of the FedBS) will likely remain at these levels for a while.

We then assume that the M2 Money Multiplier will recover as quickly as it deteriorated. By “recover” we mean return to “normal” pre-crisis levels. We calculated the average M2 Money Multiplier from January 2000 to August 2008, right before Lehman. We found this “characteristic” number to be 8.20. In the past 18 months, M2 Money Multiplier went from 8.92 in August 2008 to 3.96 in February 2010. Therefore, we will assume that it will go from 3.96 in February 2010 back to 8.20 by August 2011, in an equivalent 18 month period.

Once we have that, it is quite simple to extrapolate M2 and project it into the future, at least into August 2011, using the simple formula:



As you might imagine (and can see in the graph below), M2 proceeds to grow quite rapidly for the next year and a half.

We only need one more step to use this to estimate CPI. Since their growth is correlated, it follows that as M2 grows, CPI must grow proportionally where the coefficient of proportionality is the correlation coefficient. In other words:



Below are the results of our study, which includes all data from 1960, and the projection onto August 2011. The red vertical line marks the line where we began our projections.



Wow! So many interesting and ghastly things! For starters, of course, as the model predicted, M2 grows monotonically at a constant rate. This is by construction since we assumed that M0 was constant and that the M2 Money Multiplier would grow in tandem. Notice in the second panel that the CPI Index grows quite dramatically as well, as could be expected. And for the real kicker, the bottom panel shows the CPI Index ANNUAL PERCENTAGE GROWTH. Yikes! Notice that under the current assumptions, it will get as bad as it did in the 1970s, under Grandpa Volcker’s watch. Please see How would today's SuperInflation compare with the 1970s? to learn about the difficulties Uncle Benny is up against when trying to fight this inflation monster. Below, we zoom in for a closer look.



Same information here, but perhaps much more visceral. Notice that CPI is expected to cross the 20% barrier; it should hit 21.27 % in February 2011! Bear in mind that we are NOT contemplating inflation expectations at all. Neither are we contemplating the inflationary effects of the much higher yields that will result when people start dumping US assets as a result. Both of these factors might end up being perhaps even STRONGER engines of inflation than purely the monetary mechanism.

In summation, given the following assumptions:

1. M2 is significantly correlated with CPI, enough to use it as a predictor. (They are 97% correlated in reality)

We conclude that:

CPI would hit 21.27% in February 2011, assuming the M2 Money Multiplier returns to its “normal”, pre-crisis levels in 18 months time.

Well there you go, it doesn’t get a lot clearer than that. Adding in the additional variables previously mentioned, expectations and yields, we are quite confident in our SuperInflation prognostication. We do expect CPI to hit the 25% mark at least within 3 years.

We don’t like to give investment advice, nor interfere with anyone. We think the implications for your own investment portfolio are quite clear, and we won’t make them explicit for now. But PLEASE, we do beg you to think about this and begin to take actions to protect your capital YESTERDAY.

May your capital be safe and your investments prosperous,

MAAA