Wall Street Is Looking for Inflation in All the Wrong Places

Written by Charles Biderman, published in THE MARKET, 07.09.2020

The Wall Street Journal’s Heard on the Street column recently opined: «Milton Friedman’s famous dictum that ‹inflation is always and everywhere a monetary phenomenon› is hard to square with the Fed increasing the monetary base by 460% since 2008 with little discernible effect.

First, let’s be clear what inflation is. Inflation decreases the value of money and increases the prices of goods and services and cash flow generating assets. Deflation, on the other hand, is when the value of money rises and the price of goods and services and cash flow generators declines

Going up the abstraction ladder, human beings in aggregate require goods and services and human beings in aggregate also work at providing goods and services. Instead of bartering, money is the medium of exchange. When the amount of goods and services remains static and there is more money printed, the price of goods and services should go up – more money chasing the same amount of stuff.

However, what happens if the cost of producing those goods and services declines? The same amount of money and lower costs creates deflation.

So what happens when at the same time more money has been added to the monetary base, costs decline? The answer: The push for higher prices by more money is counteracted by lower costs and greater efficiencies.

Hence very little consumer inflation despite a 460% increase in the monetary base.

The Missing $4 Trillion

Now, let’s explain what the monetary base actually is. According to Investopia, «The monetary base refers strictly to highly liquid funds including notes, coinage and current bank deposits. When the Federal Reserve creates new funds to purchase bonds from commercial banks, the banks see an increase in their holdings, which causes the monetary base to expand

The Federal Reserve’s monetary base has actually soared to just over $5 trillion today, up from $1.1 trillion at year end 2008 – and by $2 trillion so far this year alone. And yet consumer inflation has averaged around 1.5% annually each year.

So where did the $4 trillion of newly created money go?

The answer: Asset Inflation. Typically, money left over after consumption goes into «savings». Savings is another word for financial assets such as bonds, stocks and even real estate.

What happens when $4 trillion in newly created money is injected into the US financial system, at the same time as the number of homes and shares of stock have been roughly static? The prices soar: more money available and the same number of assets to buy. The inevitable outcome is a spike in prices. Also known as asset inflation.

The Real Inflation

While there has been little inflation in the consumer sector; in 2008 the value of all U.S. bonds, government and private, was $31 trillion. Today the value of all bonds is over $45 trillion. A 50% increase in twelve years certainly sounds like inflation to me.

Take stocks. In 2009 the market capitalization of all US stocks was $9 trillion. Today it is over $35 trillion – an almost four-fold increase. Why? The total number of publicly traded shares of stock in U.S. listed companies is actually down a tad over the past 12 years. That means that companies have reduced the entire share count, by buying back more shares then all new and secondary offerings of stock.

The value of a house to live in has very little relationship to its price. Consider that virtually the same real estate from 12 years ago is now worth $10 trillion or so more than it was in 2008 according to the Federal Reserve’s quarterly Z1.

To sum it up, the $4 trillion injected into the monetary base has created a $50 trillion increase in the net worth of US Households. Which is about 90% of the entire $55 trillion gain in household net worth to $115 trillion today according to the Federal Reserve.

Now that is real inflation. Indeed, the real underlying US economy has barely grown over the past 12 years. The gap between the current price of assets and the cash flow value of those assets has never been wider.

Historically all periods of inflation end with deflation. The only question to me is when will that happen. For now, prices will keep going up. That is until the black swan flies.

Charles Biderman