Inflation concerns have been put on the backburner over the past year as the credit crisis intensified and inflation expectations declined – allowing global central bankers and political leaders to aggressively address more pressing deflationary impulses. In response to the combination of last week’s Fed announcement that its zero-interest rate policy would continue “for an extended period of time,” and the weekend’s G20 meeting in which policy makers renewed their commitment to stimulus initiatives, investors drove the gold price to all-time highs. There is a growing contingent of inflation hawks that view the colossal efforts to avoid global deflation through massive increases in the money supply by the world’s central bankers as destined to lay the foundation for a period of widespread and intractable inflation.
In spite of a strong recovery in asset prices, a contraction of credit spreads and a marked drop in volatility, the Bank of England disclosed on Friday that it was increasing the money supply by an additional 25 billion GBP ($41.9 billion USD) after the UK economy posted an additional 0.4% decline for the third quarter. Like the Fed, the Bank of England cited continuing spare production capacity as one of the factors that prompted the action.
The aggressive expansionary policies of central bankers has caused investors’ risk appetites to increase as the perception that governments will be there to step in at the first sign of any turbulence becomes entrenched. The inflation in asset prices is partly a result of investors being pushed out on the risk curve due to the fact that rates of return on capital in traditional savings accounts has been driven to zero. Although holders of risk assets have responded to these moves by driving all assets classes higher, the increase in the gold price portends an inflationary outcome as a result of the easy money policies being undertaken.
Although inflation is more popularly defined as an increase in the price levels of goods and services, it is technically a decline in the value of money caused by an increase in the money supply. An increase in the price of goods and services that is caused by a fundamental shift in supply and demand factors – say, an increase in oil prices due to the increase in aggregate demand caused by economic development in emerging economies – is not an example of inflation. However, an increase in the money supply caused by central bank policy – such as the Fed’s direct purchase of Treasury bonds or open-market purchases of mortgage-backed securities – fits the classical definition of monetary inflation. Price increases usually attend inflation because as the supply of paper money increases – without a commensurate increase in production – the excess demand manifested by a greater money supply causes the price of goods and services to rise. More currency chasing fewer goods will eventually lead to price inflation.
Although the adjusted monetary base in the United States has been growing at an increasing rate since the dollar was taken off the gold standard, it has grown by more in the last 14 months than it has in the previous 80 years to $1.96 trillion. In percentage terms, growth since August of 2008 is a staggering 125%. The next-highest period of monetary growth took place during the depression and World War II – but year-over-year growth never exceeded 28%.
Inflation doves insist that deflation still remains the primary threat to the global financial system and discount any notion of inflation, saying that there has been no credible sign or threat of an increase in prices in any of the data released over the past year despite the massive injections of liquidity undertaken by the world’s central banks. The flaw in this conclusion is that while inflation has not yet been manifested in price levels, the seeds have already been sown, awaiting germination in the form of nascent economic recovery. When recovery begins, the liquidity that now sits dormant as reserves in the banking system will flow as banks begin to redeploy reserves and increase lending. In the aggregate, this lending activity will increase monetary velocity, the factor currently missing in the inflation equation. Central banks must precisely gauge this activity, and divine the correct moment and apply the exact pressure required on the stimulus brake or inflation will sprout like weeds after a drenching rain.
Even without hard evidence of inflation, policy makers must tread cautiously. It is inflation expectations – as much as inflation itself – that central bankers must carefully manage. The threat of inflation is almost as powerful as the phenomenon itself. Business decisions become more difficult to make without stable money, hence investment often declines. Inflation distorts the economy. It causes capital to be misallocated and it destroys purchasing power. Inflation and inflationary expectations can lead to hoarding out of concern that purchases must be made now because prices will be higher in the future. It is this terrain of threatened inflation that gold investors have been eying as they push the gold price to new record highs.
According to industry research firm IBISWorld, over the five years to 2008, the price of gold has increased at an annualized rate of 19.1%. The predominant reason for the high level of growth is attributed to higher demand for gold as investors attempted to hedge themselves against inflation or a possible depreciation in the US dollar. Also contributing to the upward pressure on prices over the last five years was the increase in gold jewelry consumption, particularly as disposable incomes rise in many parts of Asia.