Low inflation expectations

Latest information from the Cleveland Federal Reserve on inflationary expectations indicates inflation is expected to be below 2% over the next 10 years. Really low inflation combined with even lower nominal interest rates spells negative real interest rates. In other words, fixed income investors are screwed.

Central banks around the world have an incentive to keep interest rates low in order to make it cheaper to service their debt. Massive printing of money to service debt should increase inflation in the long-run (due to the quantity theory of money) but apparently this is not happening. There is lots more room for fiscal stimulus. Go ahead central governments, spend, spend and spend some more.

M2 to Gold and Inflation

By most conventional measures of inflation, like the CPI, inflation does not appear to be too great of a problem for developed economies. For the US, inflation is running at 3.5% per year while for Canada it is 2.9% per year. The Canadian inflation rate is near the upper band of the Bank of Canada's target rate of 3% but so far, there is no strong indication from the Bank of Canada that it will raise interest rates in the near future. Inflation rates in China and Britain are slightly higher than 4% per year while Japan is experiencing deflation.

Another measure of inflation is to compare the M2 money supply with gold prices. The chart below shows this ratio for the US. The money supply is measured in billions of dollars and gold is measured in dollars per ounce which means that the vertical axis is measured in billions of ounces of gold. By this measure, inflation is a much bigger problem and more closely resembles what happened in the 1970s. Notice also, that the M2 to gold price ratio is indicative of equity performance. During the long bull run in equities (1980-2000) the ratio was rising. Since 2000, however, the ratio has been falling indicating a drop in the real value of money. Today's $9.6 trillion dollars of US M2 only buys 5.5 billion ounces of gold. Stocks do not do well in inflationary environments.

 

One other point. The calculation of US CPI is somewhat controversial (especially with respect to substitutes and hedonics). In the 1980s and 1990s, changes were made to the way that the CPI was calculated. If the original method of calculating the CPI is used, then current US inflation is running above 10%.