Money: Poised for Inflation?
Investors, take heed: inflation is undoubtedly on the way.
Those who pooh-pooh fears of renewed inflation cite last year's reactionary decline in the velocity of money—that is, the rate of turnover in the money supply, usually calculated as the ratio of the gross national product (GNP) to the money supply. Velocity did fall at a 2.3 percent annual rate last year, after rising an average 3.2 percent annually over the previous 22 years. High returns on dollars caused an increase in demand for money and a corresponding decline in velocity. This helped dampen inflation.
But as John Tatom observed in a recent article in the St. Louis Federal Reserve Bank Review, "It is not unusual for velocity to decline in a recession. It is, in fact, quite typical. Given the length and severity of the recent recession, it is not surprising that velocity registered the largest decline in post World War II recessions." So it would be a mistake to think that last year's drop-off in velocity insulates us from the proven inflationary effects of monetary expansionism.
Velocity has been used lately as a fudge factor to discount the expansionary nature of Federal Reserve policy. Changes in velocity certainly cannot be dismissed, but regardless of what happens to velocity, it's wishful thinking to believe the money growth we've been experiencing will not have an effect on prices.
We can expect lower interest rates and the increasing demand for goods stemming from the recovery to decrease the demand for money and increase its velocity. That means high rates of money growth will increasingly affect prices.
The 3–4 percent inflation rate we're now enjoying is unsustainable given the rate at which monetary quantities have been growing over the past year. M1—currency in circulation plus checkable deposits (including NOW accounts)—grew nearly 12 percent between the third quarter of 1982 and the third quarter of this year. The monetary base, probably a more accurate measure of Fed policy, grew by about 9½ percent over the same period. And these rapid growth rates encompass a summer slowdown in monetary growth that greatly alarmed Reagan administration officials. Since August, it appears the Fed has adopted a more-expansionary course, under great political pressure, in an attempt to bring down interest rates.
Donald Maude, executive vice-president and chairman of the interest-rate committee of Merrill-Lynch, says there's no longer any debate over whether or not the Fed has eased credit. "The only question," he says, "is the dimensions by which the Fed has eased." He cited a large decline in net borrowed reserves, which means that the Fed has been pushing more money out through its securities buying ("open market") activities and relatively less through the discount window.
Economist Allan Meltzer observed in an interview that "the Fed is trying to keep money growth as high as it possibly can, but every once in a while the market disciplines them." Meltzer is cochairman of the Shadow Open Market Committee, a group of generally free-market economists that monitors the Fed's actions. The Shadow Committee recently predicted that inflation could go as high as 7–9 percent by late 1984. Asked recently about Meltzer's inflation prophecy, Federal Reserve Chairman Paul Volcker declined to comment on the specific numbers but told me his view of the Shadow Committee: "a little extreme."
One of the unheralded reasons why our inflation rate is so low is that the value of the dollar is so high relative to other currencies. The fact that the dollar is overvalued by approximately 30 percent, according to various estimates, may be killing American exports, but it keeps the cost of our imports quite low and puts downward pressure on our price levels.
The dollar's strength will probably change soon—perhaps by a lot. In fact, a substantial dollar downtrend against the traditional hard currencies appears to have started already. Ironically, it began after the US and foreign central banks in August abandoned their joint intervention in the foreign-exchange market to soften the dollar.
There is apt to be some convergence in the coming year between lower interest rates and higher inflation, which will make real dollar yields much less attractive in world capital markets. Merrill-Lynch's Maude predicts that long-term interest rates will be brought down to 10–10½ percent and possibly below 10 percent, while short-term rates could go as low as 8 percent. They will begin to go back up, he predicts, only after the second quarter of 1984, as Treasury borrowing begins to "crowd out" private borrowers.
The factor that won't go away, though it may diminish somewhat, is the federal deficit. How is it to be financed? Currently, large capital inflows from abroad are helping. As economist Meltzer put it, "Bonds have become our major export."
But this deficit is going to put enormous pressure on the Fed as public and private demands for credit clash. Will the Fed allow budgetary financing to kill the recovery, or will it accommodate the Treasury? Volcker will try to walk a fine line between those two courses, but that will be particularly hard in an election year.
All things considered, it's difficult to imagine the Fed being able to keep the growth of the money supply near even the upper reaches of its current 5–9 percent target range. Money created over the past year is in the pipeline, and it will begin to increase inflation by the third quarter of 1984. Further relatively large rates of money growth will lead to higher rates of inflation beyond.
The commodities markets have only begun to anticipate these developments. In the coming months, they could explode. Are you poised, investors?
Steve Beckner is a financial reporter and columnist for the Washington Times and the author of The Hard Money Book.