Demise of the Dollar

[analogdog]

US Inflation Approaches 20%

This could very well be the headlines in the future, granted it may not be the "near" future. But if you look at everything that is happening right now, inflation is a sleeping giant that lurks in the darkness and is just waiting for the right time to attack.

Sure, there is a global recession going on that is helping to keep our own inflation in check, and we have been seeing disinflation even in the last few CPI reports. But is CPI a good measure of inflation, or is it really a measure of the results of inflation?

Take a look at Webster's (2000) definition of inflation, namely #2...

A persistent increase in the level of consumer prices or a persistent decline in the purchasing power of money, caused by an increase in available currency and credit beyond the proportion of available goods and services.

OK, here we see two parts to the equation, consumer prices and purchasing power, aka currency valuation. We will get back to those in a minute, but it is interesting to see the older definition of inflation by Webster's back in 1983...

An increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in its value and rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined, or a relative increase in expenditures as when the supply of goods fails to meet the demand.

You can see why the government surely favors the 2000 definition, focusing on what used to be the results of inflation (consumer prices and lost purchasing power) instead of the amount of currency in circulation. With the enormous amounts of money the government is putting into circulation, Americans will not realize what lies ahead until it is too late and prices finally rise.

Instead of looking, or rather waiting, for inflation to show in the data, such as CPI (Consumer Price Index) or even PCE (personal Consumption Expenditures), why not simply look at the value of the dollar in comparison to other currencies. The dollar has lost more than 12% of its value in recent weeks. Simply looking at the dollar versus the euro, we can clearly see this happening (the current valuation is 12.24% higher than December 8).

The fact is that the dollar is down against all major currencies except the British pound, which is actually holding fairly steady since the middle of November.

Another good gauge for inflation is the price of gold, which has also been moving higher recently. Since December 8, gold has moved from $753.70 to its current level of $881.30, a 16.93% jump.

So, why are we seeing disinflation, or even possibly deflation?

First off, one needs to know that there is a difference between the two. Disinflation is a reduction in inflation, though annual inflation remains positive, which is what we are seeing right now. Deflation occurs when the annual inflation rate goes negative, something the Federal Reserve does not want to happen and is trying to keep inflation alive (which they are doing, albeit unnoticed so far). Now, we are are seeing deflation when applied to certain asset classes, most notably oil.

Oil is sensitive to the dollar, but does not always follow inflation rates. It remains a major player in the overall inflation results however, as you have undoubtedly seen over the past year or so. The reality is that oil is like a sleeping giant, waiting to grow and grow quickly when the time comes. Oil has fallen on reduced demand buteven current prices are far lower than the drop in demand.

Here is the big problem. All of the Fed's actions, $3 trillion so far, would normally be multiplied throughout the banking system and be used to increase lending and thereby leverage funds throughout the economy. As you have seen in the media, this time is quite different than normal. Banks are soaking up the money, replenishing capital, maintaining tighter lending standards, and simply cutting back on the extension of credit. Since the banking system is not responding to the Fed's efforts, the deflationary pressures are increasing concerns about a downward spiraling economy.

The result is that consumers and businesses are now anticipating deflation and savings, along with survival, are the primary goals, which can be clearly seen in the M1 money supply chart. Of course the subsequent reduction in spending and demand drives the price of things down temporarily. We already know this will be temporary because Paulson and Bernanke have proven that the government can and will print new money to any extent needed, something even Nancy Pelosi, Barney Frank, Christopher Dodd, and even president-elect Barack Obama have already begun promising as the new year starts.

You have also seen references of our current economy with that of the Great Depression. One of the biggest differences we have now is that there is no limit to government spending, and no enforcement of monetary discipline. As president-elect Barack Obama takes office, the promises of increased government spending and more stimulus packages are already on the table. After a lag, we can expect the reinstating of credit, and inflation will be realized fully.

The bottom line is that just because we are experiencing an economic downturn, likely prolonged by the government, that does not mean that inflation will remain "moderated". Rather, when we get through this phase, we can expect to see continued poor economic conditions, only this time with rising inflation. In a nutshell, stagflation will return.