DRIVERS OF INFLATION #9
Excessive Money Supply Growth
by Monty Guild & Tony Danaher
Guild Investment Management, Inc.
July 3, 2008

Economists can not agree on what causes inflation, so we are writing a series of the ten drivers of inflation. Many people want to focus on rising food and oil prices as the reasons for the current inflation, and that inflation will go away if we get some relief in food and energy prices. We maintain that many of the drivers of inflation are pointing in the direction of higher inflation...for a longer period of time.

The ninth driver causing this current inflation is that money supply growth is excessive in many countries.

a) A popular school of economic thought holds that the rate of growth of the money supply in an economy minus the rate of growth of productivity in the same economy will equal the potential inflation
rate a year later.

b) To say it another way, if money supply growth is 10% and productivity growth is 2%, then within nine to eighteen months, inflation will be about 8%.

c) We have mentioned before that there are dozens of countries around the world with money supply growth rates over 10%, and a few with money supply growth rates over 20%. While productivity growth may be 4% in a few countries, it is generally about 2 or 3%.

d) Inflation rates are already leaping ahead in many countries. We have a global economy that is interconnected and has many feedback loops. Inflation in one part of the world feeds into other parts of the world through trade, payments, investment, and speculation.

SUMMARY

Rapid global monetary growth, in excess of productivity growth, is leading to multiple breakouts of inflation worldwide. These inflation breakouts are stimulating and reinforcing inflation among their trading partners.

INFLATION DRIVER #10: DOLLAR PEGS AND CENTRAL BANK STERILIZATION OF INFLOWS

As we discussed in driver number 9, worldwide money supply is growing fast, and excess money chasing goods and services creates inflation. China, Russia, Persian Gulf countries, India, and Brazil are growing their money supply way above the rates the governments desire. In fact, world money supply growth is estimated at 13-14% over the last
12 months.

Countries that run current account deficits, such as the U.S., Britain, and others have substantial trade imbalances with countries running current account surpluses, such as China, Russia, Singapore, Norway, and the Persian Gulf oil producers. As money flows into the surplus countries as a result of their exports, the receiving country must sterilize the inflows of foreign currency. To do this, the surplus countries' central banks must print money in their own currency in an amount equal to the inflows of dollars, or pounds, or other currency. This results in an expansion of their money supply. Eventually, having increases in money supply that exceed increases in productivity leads to inflation as we discussed earlier.

When a country has a surplus and their currency is partially or completely pegged to the dollar (e.g. China, Saudi Arabia, and other Persian Gulf states), they are in a difficult position. They must raise the value of their currency and their interest rates if they want to solve their inflation problem. However, current account countries are slow to act in this manner because even though inflation is rising, their standard of living is rising faster due to their current account surplus and the wealth the country is accumulating. This inflation ends up in the feedback loop discussed in driver number nine, and is how currency sterilization activities by current account surplus countries lead to an increase in global inflation.

SUMMARY

The last several days, we have highlighted the ten reasons why inflation is reinforcing itself and will continue. Our strategy is to protect ourselves and our clients from inflation by owning precious metals, food and food related, and energy related investments. Although we continue to like all three groups, energy has risen a great deal and food related have risen somewhat. Therefore, the most attractively priced group right now appears to be precious metals.

The first half of 2008 has been a difficult six months for almost all stock investors around the world. The U.S. market was down over 12%, and was a relative outperformer. Many major markets are down over 20%, and some like India and China are down over 30% to over 45% on the year.
 
A main focus of ours these past few months has been to preserve capital and hold high cash and T-Bill balances for our clients. We have also held the energy, food related and precious metals companies that we have been mentioning. For those clients who sell short we have been short financial stocks.

Among international stock markets, our commitment to China has been very small and we are not currently attracted to India due to the unwise policies that they have been using to deal with their inflation problem. As we mentioned, we hold cash and are thus thrilled to see periodic opportunities to buy good quality stocks in our favored sectors more cheaply when these corrections occur. It is obvious to us that buying our favored industries on corrections has and will provide good returns. We believe that this is the case because the long-term trends supporting our investment themes remain well-established. They are rising global inflation (which benefits precious metals and all commodities), the long term rapid growth of the developing world, the demand for a more protein rich diet among the world's consumers, and the need for energy and metals to build the infrastructure necessary for the world's growth.

Thank you for listening, and have a safe, enjoyable summer season.

© 2008 Monty Guild & Tony Danaher
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