At the height of the stock panic in late November, the flagship S&P 500 stock index had plunged 49% year-to-date.  Fully two thirds of this decline happened in the 9 weeks leading into the panic lows!  Naturally, the psychological impact of such an epic selloff was utterly massive.  Fear exploded to unprecedented extremes.

A stock panic is a bubble in fear, and succumbing to this overwhelming fear leads to irrational selling near lows.  Interestingly at the time, investors failed to recognize this truth.  They sold aggressively, and they wrongly assumed their selling was rational.  Of course, the only thing that warranted a 38% loss in the stock markets in just over 2 months was a new depression.  So, depression fears mushroomed.

With a depression comes deflation, so deflationary theories became widely accepted in December and January.  There was one big problem with this.  Deflation is purely a monetary phenomenon.  If prices of anything are falling simply for their own intrinsic supply-and-demand reasons, and not as a consequence of monetary contraction, then it is not deflation.  In reality, the money supply was skyrocketing in the panic.

With the Federal Reserve ramping the U.S. dollar supply far faster than the pool of goods and services on which to spend it, inflation became inevitable.  Relatively more dollars bidding on relatively fewer things means higher general prices, the formula is simple.  I wrote an essay on the big inflation coming in January, when deflation fears reigned supreme, using the Federal Reserve’s own data to highlight the staggering monetary growth.

Saying that inflation was coming, not deflation was extraordinarily controversial just 5 months ago.  You would not believe the firestorm of flak I weathered for pointing out the threat of inflation.  (Side note – Being contrarian never wins friends.)  Not surprisingly, today the consensus view on money is shifting to an inflationary bias.  With a more receptive audience not blinded by fear, I thought I would update this analysis.

Sadly inflation is woefully misunderstood in popular culture.  People tend to think it is simply “rising prices”, but this is incorrect.  The formal dictionary definition of this word is “a persistent, substantial rise in the general level of prices related to an increase in the volume of money and resulting in the loss of value of currency.”  The key is the rising prices have to be driven by an increasing money supply.
 

Consider an example.  If the Fed doubles the money supply and gasoline prices ultimately double, this is inflation.  More dollars are bidding on the same amount of gasoline, driving up its nominal price.  If some calamity takes Saudi Arabia offline, and gasoline prices double, that has nothing to do with inflation.  Supply contracted sharply as a result of calamity, demand remained constant, and hence prices rose.  These are two different scenarios leading to the same outcome, but only one is inflation.

And the reality is that prices of everything are derived from a complicated mix of supply and demand of any particular item and the supply and demand of money itself.  Usually, a given price increase has a commodity supply-and-demand-driven component as well as a separate money-driven component.  This is why it is notoriously hard to measure inflation and why average folks have a tough time understanding it.

Since separating out price effects is virtually impossible, it makes far more sense to look at the cause of inflation.  That is money supply increasing at faster rates than the underlying economy.  If you think of price inflation as smoke, an effect, then why not look for the cause or fire that creates it?  This fire is excessive monetary expansion.  When a fire initially flares brightly, there might not be smoke right away.  But there sure will be if it keeps burning!

This is an excerpt from June 2009 issue of Trader's Journal.