Everyday I see articles claiming that Fed policy is going to cause massive hyperinflation. Of course the policy we are talking about is Quantitative Easing, which we are currently in the third round of. QE3 is currently purchasing $85 billion a month in treasury and mortgage backed securities (MBS). Even though we are seeing more and more deflationary pressures, some continue to argue that inflation is picking up every day. Part of the problem comes from a misunderstanding of how monetary policy works, partly a misunderstanding about the causes of inflation, and partly because of how often incorrect terms are used, both here and in the news media.
All too often QE3 is described as "pumping money into the economy." I cannot emphasize enough how wrong this image is. The image created by the media and many of those worried about hyperinflation is that of someone at the Federal Reserve flying a helicopter over a town and dropping money into the town square. This is the classic "helicopter drop" of money as described by Milton Friedman. While a helicopter drop would cause inflation as more dollars chased a fixed amount of goods, what the Federal Reserve is doing is far from a helicopter drop. Real world monetary policy has an intermediary involved: banks. If the Federal Reserve could "helicopter drop" money, they could affect the money supply. The Fed, however, relies on banks to lend money out. The Fed can't really affect the money supply, only base money.
Here is how monetary policy really works. A trader at the Fed sitting at a computer purchases treasury bills or MBSs from a bank. The banks transfer the securities over to the Fed and the Fed transfers over the monetary value of the securities. The bank now has more money, and the Fed's balance sheet has remained intact (Assets=Liabilities). The banks then are supposed to lend that money out, which is where we get an increase in money supply and the money multiplier. That part about the banks having to lend the money out is what often gets left out in the media. Also, forget about the money supply vs. base money argument, which is similarly key. This is the amount of excess reserves currently on bank balance sheets.
Welcome to the world of a negative money multiplier. While it is fairly well known that excess reserves are incredibly high, how this affects inflation is hardly talked about. Inflation comes from the Quantity Theory of Money (M*V=P*Y). "P" is price level, "M" is money supply, "V" is velocity of money, and "Y" is output. Since monetary policy can't really affect output, it can only create the conditions for output to be increased. Thus, we need to focus on the money supply, velocity, and price.
When many people first heard about QE1, 2, or 3 they equated it with an increase in money supply. As I talked about above, the Fed can't impact the money supply. So what many predicting hyperinflation were counting on was the money supply to go up as much as base money (What the Fed can control). While it has gone up, it hasn't gone up as much as many thought. Now we get to the velocity of money: "V" has been dropping, only adding to the deflationary pressures.
This is what the Quantity Theory of Money now looks like to someone who was predicting massive hyperinflation when QE3 began.
Note that I am not saying the money supply is actually down, it’s just not up as much as some people expected when they heard billion a month in easing. This has huge implications for Gold (GLD) and Sliver (SLV) investors. To me there are two types of gold and silver investors: Those holding weak and those holding strong. Weak gold holders were those that bought in 2009 or 2010, near the peak, because of so many people saying that hyperinflation was going to come and the financial system was on the brink of collapse. Since then the financial sector has recovered and inflation has been very weak. These people are the weak holders because they hopped on a trend at the wrong time, much like buying Apple at 0. The biggest problem with weak holders is that they are emotional about their Gold position. The strong Gold investor on the other hand most likely owns physical gold or some combination of physical gold and the gold ETF; this position is a long term inflation (not hyperinflation) hedge. A couple of years ago I bought a couple of silver coins. At the time silver was trading at and I think I paid for them. They are somewhere in the house, but I don't think about them often, nor do I consider myself to have lost money. I bought the silver as a long term hedge for inflation, despite the fact that I don't expect us to see higher than normal levels of inflation anytime soon. One thing that I have learned in my short time investing is that it always pays to be hedged, no matter how strongly your conviction in a trade. Just because I own a couple pieces of silver, don't think I bullish on Precious Metals, in fact I am quite the opposite.
One of gold bulls’ and hyperinflation predictors’ favorite things to point out is that no fiat currency has ever ended without hyperinflation. I think this is a silly argument, mostly because it ignores the bigger picture. The fact is that commodity currency systems fail. On the island of Yap in Micronesia they used huge stones cut into disc shapes as a currency. That currency isn't around today, so does that mean we shouldn't have rock based currency? The answer is obviously no. There are many, many fiat currency systems that still exist, just look around the world. Fiat currency haters (Who are also usually gold bulls) are saying, "But all fiat currencies will eventually fail." True, but nearly every civilization throughout time has failed at some point! That's not an effective argument against fiat currencies either.
There is one main reason I don't think that we will see hyperinflation and it has to do with something the Fed did in the midst of the financial crisis that seemed counterintuitive. On October 6, 2008 the Federal Reserve announced that it would begin paying interest on deposits held at the Fed. This seemed particularly odd given that the Federal Reserve was trying to get the banks to lend and increase the money supply. What that did is it now gives the Federal Reserve yet another tool to use if it wants to contract the monetary base or tighten the cost of credit. I think that in the next decade when people talk about monetary policy a good part of that conversation will involve what the interest rate on deposits is.
One last important note. Just because I am arguing against hyperinflation does not mean I am a permabull. I think that things could get ugly for the market when the Fed starts unwinding. I would be hesitant to short or buy the market here. For the first part of this year I have had a very large portion of my portfolio in index funds, which had treated me nicely. I have been rotating both long and short as I fully expect to see greater differentiation through the rest of the year.
