We currently are in what Mr. Coxon identifies as the first stage of inflation. The Fed has pumped enough fiat money into the system to float the entire financial world. And there is much more to come, as the Obama administration’s huge spending bills for economic stimulus, health care, and green regulation pour more trillions of dollars into the stream. The Federal deficit, already far past previous levels, will continue setting dangerous records.
The first-phase inflationary effect is evident in the tremendous rise of the stock market so far this year. Investors have been sitting on the sidelines with tons of money to invest. The stock market surge (most likely a bear market rally) has led them to leap into the market in anticipation of higher corporate earnings.
The stock market historically trades at a price/earnings ratio around 12 to 15. Currently the price/earnings ratio of the S & P 500 is north of 40, which means that, unless corporate earnings soar at an incredible rate, the stock market is much over-priced and due for a sharp correction.
That means also that the stock market surge (the Dow Industrial Index has been flirting with 10,000) is not really an indicator of current economic performance. It’s just a reflection of too much fiat money seeking an outlet.
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Dropping large chunks of newly created money into the economy leads to price inflation, because the recipients are likely to find themselves overprovisioned with cash. As they try to unload the excess, they bid up the prices of the things they buy, whether it be stocks, shoes, gasoline, silver coins, or granola. The sellers of those things then find themselves cash rich and start doing some buying of their own, and so the wave of excess money and the bidding it inspires propagate through the economy.
The process isn’t instantaneous. It takes time. Just as each player in the economy has a sense of how much of his wealth he wants to hold in the form of money, everyone will move at his own speed to make adjustments when his actual cash holdings seem to be off target.
And the process can seem to stall, especially when fear is growing. When people are worried or otherwise feel a heightened sense of uncertainty, they will gladly hold on to abnormally large amounts of cash – for a while. But when fear abates, as it will when the economy begins to recover from the recession, that temporary demand for extra cash will also fade, and the hot-potato process of trying to pare down cash balances will emerge to do its inflationary work.
But when?
The speed at which the public tries to unload excess cash and the timing of the effects have actually been measured, in the work of the late Milton Friedman and his monetarist colleagues. The method was indirect and roundabout, and so the results, unsurprisingly, were nothing as precise as nailing down the value of a physical constant.
What the monetarists (or the first of them to be equipped with computers) found was that when the growth rate of the money supply rises:
- The initial effect is on the prices of bonds and stocks, an effect that comes within a few months.
- The peak effect on the growth rate of economic activity comes about 18 to 30 months after the pick-up in the growth rate of the money supply.
- The peak effect on the rate of consumer price inflation comes about 12 to 18 months after that, which is to say it comes 30 to 48 months after the peak growth rate in the money supply.
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