Current price inflation data confirm all trends and expectations associated with monetary inflation. In recent years, both the official and the alternative indicators of consumer price inflation point steadily towards stagflation.
 

The price inflation chart above clearly indicates that since 2002 inflation has been steadily accelerating.

At the same time, as you can see in the chart below, economic growth has been steadily slowing since the beginning of 2004. The last three years represent a period of accelerating price inflation and slowing economic growth, irrespective of whether one uses doctored government statistics or the SGS-adjusted numbers.
 

Compelling evidence of stagflation has emerged from the statistics so far this year. A sequence of weak jobs reports have convinced many renowned economists that the U.S. economy slipped into a recession either in December of 2007 or in January of 2008, even though the mainstream continued to opinionate even in August of 2008 whether the U.S. will slip into a recession. Most likely, the U.S. economy has been in recession over the last 5-6 months, while at the same time inflation has been steadily rising and approaching levels uncomfortable even for Wall Street and FOMC members.

While many openly dispute the recession hypothesis by claiming that the U.S. can dodge a recession, at this point pretty much everyone agrees -- even Fed Chairman Ben Bernanke -- that the U.S. economy is stagnant, growing close to zero percent. At the same time, observers across the board have acknowledged rising consumer price pressures.

Literally every meaningful indicator is pointing to continuous price inflation in coming years. The most obvious indicator is inflation’s momentum. Despite macroeconomic stagnation (or outright recession), inflation has continued to accelerate.

The second obvious driver of price inflation is a steadily weakening dollar against all other currencies, despite the dollar bear market rally during the last 3-4 months driven most likely by Wall Street deleveraging. Since the beginning of the Credit Crunch, the dollar has fallen between 10 and 20% against a wide basket of currencies, suggesting steadily rising prices of imports, while the recent relief rally will most like prove to be an intermediate correction. More importantly, many exporting countries, like China and India, are reporting accelerating inflationary pressures in their economies, indicating rising prices in their own currencies, which in turn will translates into even higher prices in U.S. dollars.

The third driver is the rising price of energy on international markets. Rising crude and gas prices will filter eventually through consumer prices as production costs rise. In a sense, the “Third Oil Crisis” is unfolding in slow motion as the price of crude has doubled during the last year. Such a 12-month increase in the price of crude has always resulted in a recession coupled with rising price inflation, even though the price of oil eased after the price spike. In other words, spiking oil prices are highly stagflationary. While it is true that the oil has corrected almost 50% in few short months, the price of oil will resume its upward move; we have seen similar corrections many times before, most notably in January of 2007.

The fourth driver is the evolving “Food Crisis”. In my opinion, there is no food crisis and there is no shortage of food. There has been a small decrease of output in highly inelastic agricultural goods coupled with steadily rising demand that has resulted in food prices almost doubling in a very short period of time. This is a classic textbook example of basic Econ 101 that we typically teach freshmen in their third week of the semester.

For example, in my home country Bulgaria, there is no shortage of any agricultural commodity – any can be had, albeit for a lot higher price than a year ago. Similarly, during the last month I have been living in Saudi Arabia and I have never heard once anyone mention anything about food “shortages”. It seems to me that the journalists’ quest for sensationalism naively associates rising food prices with “Food Shortages” or with a “Food Crisis”. They show us images of emaciated children in poor countries caused by the Food Crisis, while the simple truth is that these poor are starving because their parents have low incomes and cannot afford the rising price of food. The root of the problem is not the lack of food, but the lack of income.

In reality, what has happened is that after so many years, food prices are finally beginning to catch up with other prices in the economy – with real estate prices and with stock market indexes, for example. Essentially, the whole commodity complex is making up for lost time during the 1980s and 1990s. Commodities still have a lot to rise in order to realign their values to stocks, bonds, and real estate; or alternatively, stocks, bonds and real estate prices must collapse relative to commodity prices. Here, I prefer a monetary argument: given that the Fed has been flooding the markets with liquidity over the last 9-12 months, it is unlikely that stocks, bonds, and real estate will adjust significantly downward, but much more likely that commodities will adjust upward, which spells even more consumer price inflation down the line. Rising commodity prices, just like rising oil prices, spell stagflation. Do not be fooled by the recent fall in commodity prices.

The fifth driver is the rapidly rising inflationary expectations. As an illustration, consumers feel that rice will be more expensive next month or next year, so they decide to stock up on rice, which drives its price much higher. Suddenly rice is hard to find, so consumers begin stocking up on all sorts of foods. That makes all food prices react violently upward, which in turn triggers governments across the world to impose export quotas, which in turn further feeds the buying frenzy. Now, consumers seeing all sorts of prices rising (such as imported underwear and apparel or necessities such as toothpaste and toilet paper) will rationally decide to purchase many of them in advance, in anticipation of more rising prices. The obvious result: even more price inflation.

The sixth driver is the government’s stimulus packages. This summer the consumer benefited from a few hundred billion dollar stimulus package and Ben Bernanke testified again in front of Congress in October 2008 that yet another fiscal stimulus is necessary. The consumer has plenty of options, like paying down debt and investing the money in stocks and bonds, but the most likely outcome is that the majority of money will be spent of food and energy, thus further driving their prices higher and further exacerbating an already acute inflationary problem.

The above is sufficiently important to warrant a detailed explanation. In essence, the current price inflation has squeezed the consumer to the point where a much larger portion of his income goes to food and energy. Demand for these two critical items is very inelastic, so most extra income will be directed towards them. The key to understanding the outcome is the fact that food and energy supply is also very inelastic– consumers can willingly pay higher prices, yet businesses cannot respond with increased supply of food and energy. The nature of providing (supplying/producing) food and energy is such that it entails significant lags in time, often three, five, seven or more years. Thus, increased demand for food and energy driven by the Bush stimulus package(s) will likely result in significant price inflation and little economic growth. As a counter-example, consider that if consumers were to decide to spend their stimulus package cash on massages and fitness trainers, it would result in booming massage and fitness industries hiring more massage therapists and fitness trainers to expand their services; with food and energy this won’t happen—it won’t translate into jobs or growth.

A host of other factors contributing to exacerbating stagflation can be offered here, but the overall message should be clear. Price inflation has strong, long-term drivers that are here to stay for many more years. Unless another Great Depression truly chokes consumer demand, inflation is only going to get worse.

Everything on the monetary side points to more inflation in the future. Nevertheless, over the last half a year—especially since the “Credit Crunch” has gained strong momentum—deflationists have been emboldened to proclaim yet again that the economy will spin into a dreadful deflation, dragging everything in sight with it. I can understand the deflationist warnings, as I was once a deflationist, schooled by Robert Prechter, the Dean of the Deflationist School. His book Conquer the Crashis the ultimate reference book on deflations, The Deflationist Bible. Whether one believes in a coming deflationary depression or not, one must nevertheless read the book and understand its arguments.

The quintessence of Prechter’s book is that inflationary booms cannot last forever; here Austrians will eagerly agree. However, Prechter argues that inflation cannot last forever and that deflationary forces will overwhelm the financial system, so that the economy will tailspin into deflation; here Austrians will disagree, as they admit to the possibility of an inflationary bust, i.e., a stagflation.

Prechter provides (in Chapter 13, p. 130) three limits to credit expansion that we can actually observe. With these, we can determine whether monetary inflation can continue or not. His first limit on credit expansion is the rising price of gold; the second is the falling dollar, and the third is rising interest rates (due to rising inflationary expectations) and corresponding falling bond prices, which in itself is strongly deflationary. In Prechter’s terms, the three countervailing forces to inflation come from the gold market, the bond market, and the currency market.

Over the last six years, I have found these criteria to be extremely helpful, especially in determining whether the environment would turn deflationary any time soon. It is easy to analyze each and see if any currently represents a genuine limit to credit expansion.

1. Price of Gold:The price of gold has been steadily rising for the last seven years and it has not yet deterred the Fed from inflating. Clearly, whether gold rises to $1,000 or $2,000 or more, the Fed will remain unmoved by its rise. Also, just because the price of gold has been correcting for the last 3-4 months does not mean that deflation is here. An intermediate correction does not make a secular trend!
   

1. Dollar.Moving to the second limitation, apparently the Fed pays only lip service to the government’s Strong Dollar Policy. In reality, the Fed seems to like the idea of a falling dollar, as long as the fall is orderly. The Fed would most likely be pleased to see the dollar a lot weaker in the future, provided again that the devaluation is “orderly”.
2. Interest Rates.This third limitation is no limitation at all to an Inflationist Fed hell-bent on preventing deflation. The Fed has devised a number of ingenious approaches to support the long bond and has even stated in public that, if necessary, it will monetize the long end of the curve to support high bond prices and respectively low bond yields.

The deflationist arguments resting on gold, the dollar, and the long-bond yield apparently present no problems for the Fed at all. In reality, the Fed can inflate at will, and this is exactly what it’s doing!
At this point, there appears one, and only one, limitation that will force the Fed to slow down its monetary inflation and compel it to raise interest rates – a Dollar Crisis associated with a flight out of dollars and a panic in the currency markets, triggering a colossal currency derivative crisis.

Nothing short of this will constrain monetary inflation. At this point, it is my opinion that so long as the dollar devalues in an orderly manner, or the dollar actually rises against other fiat currencies, the environment will remain strongly inflationary.

Other deflationists have raised a very powerful argument in their favor. Typically during an asset deflation, where the prices of stocks and real estate fall, there are no willing lenders and no willing borrowers, no matter how low the Fed lowers interest rates. This is dreaded condition is known as “pushing on a string”. The classic example is Japan since 1990.

The counterargument is straightforward: in modern fiat monetary systems: the Central Bank is always a willing lender of last resort and the Government is always a willing borrower of last resort. In order to prevent contraction of credit, the government can always borrow and the Fed can always monetize – credit contraction and deflation do not have to occur when the Fed and the government do not allow it to happen.

So far, it is more than obvious that the Credit Crisis has not prevented the Fed from its inflationary course, despite the rhetoric to the contrary. In reality, the Credit Crunch combined with a contrived deflation scare and a rising dollar has provided a cover for the U.S. government to increase its budget deficits and an excuse for the Fed to inflate further. All monetary indicators confirm that the Fed has been successful in this regard

Until this past October the growth in the supply of the monetary base (i.e. M0) in the U.S. over the previous 48 years had averaged 6% year-over-year (YoY) and had seldom exceeded 10% although it did grow to 15.8% YoY during the pre-Y2K period. Indeed, during the first half of 2008 it was actually trending lower averaging 1.2% growth before all hell broke loose.

In October, however, as a result of a number of major fiscal developments, the Fed took it upon itself to solve the major problems with the economy by expanding the M0. To say they didn't act in half measure is putting it mildly - very mildly!

As Adam Hamilton reports in a recent article, and his chart below depicts, the Fed increased the M0 by 25% (36.7% YoY) in October to more than twice the level seen in the previous five decades; by a further 27% in November (73% YoY) and another 15% in December to 98.9% thereby doubling the U.S. monetary base in just 4 months. Such action was unprecedented and put the country into unchartered inflation territory. But it didn't stop there. In January the Fed increased the YoY monetary base to 106%, increased in yet again in February, and again in March, and again in April (the May numbers are not yet available) to an unbelievable YoY of 111.0%. That's right. 111% when the norm over the previous 48 years had been just 6%! Surely this monumental increase in America's M0 will have a majoraffect on real prices.

The monetary base numbers are shown in red above and their YoY growth rates in blue.

As consumer spending recovers and bids on now-depleted inventories rebound prices will also rise for pure supply and demand reasons says Hamilton maintaining that "we're probably facing a perfect storm of inflation." I couldn't agree more! As inflation becomes more obvious to the masses inflationary expectations will soar and investors will seek assets that thrive in inflationary times i.e. commodities in general and gold and silver in particular and their stocks and associated warrants.

Inflation is dead - long live inflation! We hear about the threat of hyperinflationin the media - is this for real, can it happen in the U.S.? Are we hyping up the word inflation, is it an inflationary play of words to grab attention to discuss the threat of hyperinflation? Let's deflate the hype and put inflation where it belongs... at the forefront of your concerns.

Stop right here. In the words of European Central Bank (ECB) President Jean-Claude Trichet, what we suggest is " extraordinarily counterproductive." Discussing how policies pursued by the Federal Reserve (Fed) and other central banks might lead to inflation makes the job of central banks more difficult. That's because the best predictor of future inflation may be inflation expectations. If people think there will be inflation, they are likely to have higher wage demands; similarly, businesses that believe inflation is baked into the system may continuously try to push for higher prices. The head of the ECB recognizes this and is rightfully concerned that this talk about inflation may lead to, well, inflation.

In contrast, the Fed wants to make us believe that there is so much "slack" in the economy - economists call this the output gap - that there is nothing to worry about, inflation won't happen. What the Fed and the ECB have in common is a "trust us" attitude, telling us that as long as we put our faith into the mighty hands of central bankers, we will be fine. And that's where the fundamental problem lies: rational investors ought to make investment decisions based on an evaluation of facts, not based on nice talk by central bankers. At least the ECB talks straight; the Fed, however, started out by trying to square the circle. As squaring the circle may be impossible, the Fed is likely to add a dimension, possibly turning the circle into a balloon - inflation if you will. If the balloon pops, we get hyperinflation.

The squaring of the circle is the phase we are in right now. A massive monetary and fiscal stimulus has been initiated to counter market forces. As a result, home prices have not fallen enough to be sustainable by incomes without substantial government subsidy - this may be the root of a most unstable situation that may lead to a fragile recovery at best. With interest rates low enough, the economy may indeed bounce from the bottom - economic activity had fallen to such low levels that many businesses had seen their inventories completely wiped out; if businesses wanted any sales, they had to buy at least some supplies.

But in our humble opinion, the squaring of the circle is doomed to fail and the first signs are showing up in the bond market. That's because the government piled on trillions in debt this year in addition to running the printing press in high gear. Investors are becoming concerned that this magic wand might just be inflationary down the road. If, and that's a big if, there is confidence in the Fed that it can engineer an economic recovery that is not inflationary, then the bond market will behave; once the economy is back on track, the Fed will mop up the liquidity it has poured into the markets; the administration will scale back its spending programs and present a balanced budget; and we will have Martians visit planet Earth. The likelihood of each of the aforementioned happening may not be identical, but listing the Martians in conjunctions with the remainder may give you a sense of our confidence in any or all of these being realistic.

Don't underestimate the Fed, though: unless the public and foreign lenders completely lose confidence in the Fed, it has the power to control inflation expectations in the medium term. That's why the markets react to Fed talk - when the Fed says all will be well, the gut reaction in the markets may be a sigh of relief. Even when Fed Chairman Bernanke warns Congress about unsustainable deficits, the markets seem appeased as if to express that Bernanke will impose discipline on Congress through higher rates if necessary.

The real question, however, is whether the Fed is going to follow through on its promise to keep inflation in check; a task that has been made ever more difficult as the Fed has piled up mortgage securities on its balance sheet that may be difficult, if not impossible, to sell again; or at least neutralize the economic stimulus created with this and other "credit easing" programs. The challenge is that inflation may show its ugly head well before we have a sustainable recovery. As pointed out earlier, even if we have economic growth, we don't think any recovery is sustainable if home prices continue to be only affordable at interest rates that are highly subsidized. That's where the squaring of the circle is likely to fail.

The Fed may actually want to have inflation to push up home prices; remember that inflation bails out those with debt (and punishes savers). Fed Chairman Bernanke has repeatedly argued that going off the gold standard during the Great Depression and allowing the U.S. dollar to fall versus other currencies was the key to ending the Great Depression. The Fed's credibility is in jeopardy as it increasingly attracts political scrutiny; that's because the Fed is meddling with fiscal policy these days: rather than "merely" printing money and setting interest rates, the Fed is providing money to specific sectors of the economy - the various lending and credit facilities, as well as active purchase programs of mortgage backed securities, amongst others, is squarely in fiscal territory, something that should be governed and supervised by Congress, not a central bank.

Some central bankers are so frustrated with this talk about inflation because it further undermines their credibility - and credibility is key for central banks to get away with the policies pursued. There's a simple solution to this mess: have central banks stop the printing presses, have central banks stop meddling with fiscal policies. If the Fed were to stop being engaged in the pursuit of what we believe may be highly inflationary policies, we wouldn't need to warn about them in public! We are not alone in our calls: German Chancellor Angela Merkel recently received worldwide attention when warning central bankers that they must stop the printing presses. The warning carried all the more weight as it is most unusual for a German Chancellor to interfere with the independence of central banks; please view a replayof our discussion of the episode with Neil Cavuto on FoxBusiness TV.

The reason why our calls may fall on deaf ears at the Fed is because the Fed is concerned that a premature unwinding of its programs could throw the economy into a depression - all the work to date to stabilize the markets might be in vain. We respectfully disagree in particular with the latter. Last October, the guarantee of the banking system ensured that the potential of a disorderly adjustment of the U.S. and global economy was averted; it opened the opportunity for an orderly adjustment. Orderly adjustmentis a nice phrase for what may be a depression, but the alternative, inflation with the threat of hyperinflation may be, in our humble opinion, the worst of the alternatives.

Now we mention it again: hyperinflation. So is it a real threat? The simple answer is: it depends on how the dynamics play out. What we do know is that all hyperinflation in the world has started when a country's central bank prints money to finance government spending. The Fed adamantly denies that that is what it is engaged in, but when something looks like a duck, swims like a duck, quacks like a duck, we call it a duck. We intentionally use such strong language to send a strong signal that the policies pursued, in our view, are reckless and dangerous.

We are based in California where, when one plays with fire, a lot of damage can result. Incidentally, California's budget woes show just how serious the financial situation of many states is. State and local taxes are likely to go up, budgets will be cut further. Everyone is screaming for money; while even the Fed may not be able to save California, the Fed may be extremely reluctant to stop its accommodating stance given the grave situation so many consumers, municipalities and states are in.

In our assessment, the scenario the Fed would favor is a prolonged period of elevated inflation; some estimates are from 4% up to 7% or 8%; others higher - that's the circle turning into a balloon. But the Fed cannot allow inflation to grow that high without a serious plunge in bond prices, pushing the cost of borrowing for home owners, as well as the government, to very high levels. We would like to point out that the government currently pays fairly little in interest expense since the government played the same "adjustable rate mortgage game" consumers did; remember how the government phased out the 30 year bond ("long bond") during the Clinton administration? Well, the "long bond" is back, but 40% of the federal debt is maturing this year and has to be rolled. It has been puzzling that the government has not taken more advantage of the low long-term rates; a strategy we believe will exacerbate the cost of government debt in the long run.

Back to what the Fed may be most concerned about: the economy, in our view, is likely to stall with long-term rates going up much further, if the Fed is not able to keep mortgage rates low. Right now, the Fed is very actively subsidizing this market, printing a lot of money in the process. At some point, we are concerned market forces will overwhelm the Fed. Right now, the Fed insists it is not trying to keep rates down; it is merely "facilitating" the flow of credit. We believe such comments undermine the Fed's credibility as, for example, the massive purchases of mortgage-backed securities, are in our view clearly aimed at keeping rates low.

Nothing during the financial crisis seems to have worked as planned by the Fed. Policies have been far more expensive as the Fed's credibility has eroded. The Fed has repeatedly shown that it completely underestimates the political dimensions of its policies. Will the market really buy its tough talk? And if not, what will happen? If the Fed substantially increases its market interference, it can lead to hyperinflation down the road. How likely? We are reluctant to quantify it, but the risk is real. The appropriate way for the Fed to regain credibility may be to not only announce that there is a viable exit strategy to the policies that have been pursued, but to embark on it. So far, this hasn't happened, the printing press continues to be very active with the Fed's balance sheet growing steadily. We hope the balloon won't pop, but hope is not a strategy.

Needless to say, these policies may be detrimental to the U.S. dollar because foreigners may have little interest in buying bonds with artificially low yields due to the Fed's activities; while the U.S. should be able to finance its massive deficits, lenders want to be compensated with free, i.e. market-based prices. Did we mention that we believe the Fed may favor a weaker dollar? It might just be getting more than it is bargaining for.

What is a Gap?