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Thursday, December 31, 2009

We're headed for high inflation

Even as the Dow sits above 10,000, the public remains justifiably anxious about the state of the economy. The Federal Reserve has worked overtime to convince the public that it has saved the economy from a meltdown, but with unemployment at a 26-year high and the dollar tanking, it's a hard sell. What most people easily understand is that the Fed has produced a monetary time bomb. Since August 2008 the monetary base (bills in circulation plus bank credits at Federal Reserve banks) has increased by 137%. If not defused, this bomb will eventually explode into inflation. We are told by Fed Chairman Ben S. Bernanke and other members of the Fed's bomb squad not to worry. They assert that they know how and when to disarm the bomb.

Such assertions are a stretch. After all, it was the Fed's ultraloose monetary policy and disregard for the value of the greenback that fueled the asset bubbles that burst and set off the panic and subsequent destruction of jobs and wealth.

The time bomb hasn't exploded yet because, for now, the expansion in the monetary base has not given rise to a comparable expansion in a broader measure of the money supply called M2. That's the monetary base, plus demand deposits (commercial and individual) at banks, traveler's checks, savings accounts, time deposits and money market mutual funds.

The key here is something called the money multiplier, which is M2 divided by the monetary base. The multiplier measures, in a sense, the inflationary bang from every buck the Fed creates. In August 2008 the multiplier was 9.1. By December 2008 it had collapsed to 4.9 and since then has declined along an irregular path to 4.2. When the demand for the more narrowly defined kind of money goes down, as it eventually will, the money multiplier will move back into a normal range of 8 to 9. That is, the dollars manufactured by the Fed will give rise to more money (broadly defined) burning holes in people's pockets. An excess of money in spenders' hands is a recipe for inflation. This is when the Fed will need to shrink its balance sheet, but it will not be willing to do so because unemployment will probably still be elevated. In this scenario inflation expectations will become unhinged and inflation will accelerate.[Emphasis added]
--from "Income During Inflation / Bonds are a risky venture when inflation is set to explode at any moment. Play it safe. Go for dividends." by Steve Hanke

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