Inflation or Deflation: Which is it?

"Inflation is always and everywhere a monetary phenomenon."
- Milton Friedman

One of the most memorable and most quoted lines of the late Milton Friedman is summed up in another cliché of the quasi academic world of the dismal science, "too much money chasing too few goods."

Inflation: Buy NOW

Friedman taught us that money is essentially a good or commodity, and its value is determined by supply and demand. One of the consequences, and not the cause, of inflation is the increasing price of goods. When we realize that today’s money is likely to buy less goods in the future, we stop saving for the future and look for ways to spend it now. In so doing the unsaved money increases the frantic chase to buy goods now.

Inflation, in other words, occurs when money becomes less valuable relative to the cost of goods. This can happen when:

1. The supply of money goes up
2. The supply of assets goes down
3. Demand for money goes down
4. Demand for other goods goes up

The most common cause of inflation is when the money supply rises faster than the supply of other goods and services.

Money has value only as long as people believe that they will be able to exchange their money for goods and services in the future. This belief will endure so long as people do not fear future inflation. To avoid inflation, central banks are mandated to maintain price stability. To this end they are to ensure that the money supply does not increase too quickly.

The Velocity of Money

Deflation is the very opposite of this. Commonly deflation is defined as falling prices but falling prices are the outcome of the underlying fault and not the cause. The cause is always and everywhere, to borrow Friedman’s words, a decrease in the money supply. Further studies show that equally important are the velocity of money, i.e. the money multiplier in the economy. When both these factors are in decline, recession or worse is heading full speed our way.

What is ‘The Money Multiplier'?

M3, which is the aggregate of a broad range of bank accounts, has been abandoned by the Bernanke Federal Reserve since 2050, but it is still tracked by British and European monetarists. M3 started contracting at an alarming rate last summer warning about the direction of the US economy a year or so in advance. This year the pace has quickened. The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6%. The assets of institutional money market funds fell at a 37% rate, the sharpest drop ever. This plunge in M3 has no precedent since the Great Depression.

The Money Multiplier, MM, is of fundamental importance in national monetary policy. In the U.S. from 1959 through September 2008 banks lent out close to the maximum allowed. Then the broad money supply was approximately equal to central bank money times the maximum MM allowed.

During that period the multiplier was often a 5 times factor or higher. During the great depression and again since 2008, banks have been accumulating excess reserves, i.e. not lending money, and the MM declined significantly. Through 2009 lending fell by over $100bn that was a record 10% absolute decline, plummeting at a record annualized rate of 16%. It seems that even before this year was underway a double dip recession, or worse, was the writing on the wall for the later half of 2010.

The Road Ahead

Recent indications strongly suggest that a resurgence of the recession is on track now that the temporary effects of cash for clunkers, discounts for first time home buyers, etc. have expired. CPI is headed south along with consumer confidence.

Money, as commodity, depends on consumer faith in its value. It seems the ordinary Joe has more confidence in money now than at any time in recent memory. That is why Joe and Jane Doe are saving their money in significant amounts for the first time in years. During deflation the relative value of money increases as we realize that today’s cash will buy more tomorrow as prices decline as deflation deepens. Governments despise ordinary folk like us, particularly this elitist socialist Obama government, while all the time the actions of the people are clearly pointing out the road ahead - deflation.

Cash is King?

After a period of economic contraction the over capacity and over production that we see at the outset of the deflationary period will be eliminated. At some point, be it in 5 months, 5 years or 30 years, prices will get so low, and the hoarded money will be so great that buying will once again begin. Then we will likely see inflation get underway and increase at an alarming rate, as there once more will be too much money chasing too few goods.

So for investors, "cash is king," is not necessarily bad advice to follow at this time. For traders this is not the way to go. In all periods of economic activity trade occurs and markets exist to facilitate that trade. Generally speaking asset prices decline during deflationary periods so trend following traders would for the most part be short sellers. However from time to time declining markets are given to volatile short covering rallies that can move quickly and to unsuspecting levels of correction. These offer further opportunities to profit from trading during deflationary times. Market Profile or Auction Market Theory, offer reliable means of recognizing and understanding market structure and low risk levels for trade location.

Straight Ahead: Renewed Deflation?

We can expect renewed deflation immediately ahead. The depth and duration of the deflationary spiral could well be of 1930’s depression proportions. Through this period, the value of money will increase. Investors holding cash ready for the next bull market in assets is not a bad thing to do. Traders on the other hand should continue to trade the opportunities in changing asset prices in markets that facilitate trade.

Trade well and follow the trend, not the so called "experts".