The London based Telegraph ran an article in which Lombard Street Research was quoted as saying that the US money supply experienced its sharpest contraction on record in July (link). On an annualized basis M3 increased by only 2.1% from May to June, according to the article. In June M3 fell by $50 billion, which they claim is the biggest one-month decline on record since M3 was first published in 1959.

I understand the desire to look at shorter time frames than year-over-year changes, but I must again caution against drawing conclusions from short-term fluctuations. The year-over-year inflation rate calculated from the Actual Money Supply peaked at 9.38% in March and has steadily declined to 7.80% in July. Preliminary data for August suggest the inflation rate has continued falling and is now below 7%. However, the average inflation rate for 2008 thus far is still well above 8%, which is historically very high.

It is possible that April marked the end of inflation, and that deflation is in the cards, but we cannot be sure of that just yet. The market is betting it is, as is evident in the recent rise in bond prices. I am still bearish on bonds and would want to see the Actual Inflation Rate keep falling before I change my bearish stance towards US sovereign debt. I am not yet willing to bet that Bernanke has thrown in the towel in his fight against deflation. In theory the Federal Reserve Bank can always avoid deflation -- it can create an unlimited amount of fiat money. The current pause in inflation may just be a tactical respite to dampen speculation in energy and food that have caused those prices to rise far above any realistic measures.

It may seem as if the debate over whether we are in an inflationary, or deflationary environment is merely an academic exercise of interest to economists and other people who don’t have real work to do. But actually it is not -- the prospect of future inflation or deflation is a material consideration for anyone trading bonds and all homeowners with mortgages. In fact, it is material to many financial decisions we have to make. There are very real, and very strong deflationary forces at work and the prospect of deflation should not be taken lightly. At the same time, it is too soon to call inflation a thing of the past since the year-over-year inflation rate for the first seven months of 2008 is still higher than the average inflation rate during the 1960s and 70s.

Inflation is an increase in the money supply and deflation is a decrease in the money supply. An increase in the money supply (inflation) will always cause prices to be higher than they otherwise would have been while deflation (a decrease in the money supply) will always cause prices to be lower than they otherwise would have been. Inflation is not an increase in prices per se; an increase in prices may be the result of inflation, or something else. Similarly, a decline in prices is not deflation, but deflation can cause a decline in prices.

The deflationary argument centers on the observation that bank assets, such as mortgages, credit card loans and other consumer debt, have been falling in value. The decline in the quality and value of these bank assets has put tremendous stress on the banking sector. However, it is important to understand that a decline in the value of bank assets is not the same as a decline in the money supply, which are bank liabilities and not banks assets. Therefore a decline in the value of bank assets is not, per se, deflationary. Even as these assets have been falling in value we have seen tremendous growth in bank deposit accounts, which form the bulk of the money supply, and therefore we are still, absolutely and categorically, in an inflationary environment.

Bank deposits can grow even as bank assets decline in value. The difference is a reduction in the banks’ equity, and the reason for the collapse in bank share prices. In other words, we can have inflation even though gross bank credit, when measured as bank assets, declines, but not indefinitely. Eventually the decline in bank assets has to halt, or all the banks will become bankrupt, which is why the deflationary argument cannot be summarily dismissed.

The decline in the value of bank assets has already wiped out an enormous amount of bank equity. To understand just how dire the situation is, consider that when banks borrowed 46% of their reserve requirements from the Fed in March 1933 President Roosevelt declared a bank holiday, yet US banks in aggregate are currently borrowing 295% of their required reserves from the Fed. Yes, that is correct, they are borrowing almost three times more than their reserve requirements.

In a normal, free-market, capitalist system, that would spell grave danger, but the US is not a free-market, capitalist system any more. Whenever big corporations, banks, or enough consumers, get into real trouble the Government or the Fed will step in to make things seem better. That is the only reason we have not seen the massive deflation so many people are anxiously expecting. The Fed could just create the money to shore up banks’ balance sheets, but that is not the desired course of action, so it is keeping the banking system on life support while it waits to see if the situation is going to improve, or whether more intervention is necessary.

I am not a proponent of intervention, and would have preferred to let the market sort this mess out, but that is not what is happening and we have to consider what is happening rather than what should have happened. Eventually, a long time from now, the market will have to sort out the growing imbalances being created by Keynesian stamped policies, but that time has not yet arrived as far as I can see.

Bank failures during the 1930s caused the deflationary economic collapse known as the Great Depression. The economy would have collapsed anyway -- the depression was necessary to cleanse the system of the Roaring Twenties, but it was the failure of banks that wiped out depositors’ accounts (i.e. money) that made it a deflationary depression.

Bernanke is one of the foremost students of the Great Depression and like most Keynesian economists believes that deflation can, and should be avoided at all cost by central bank intervention. We will continue to monitor the US money supply closely to see whether it’s Bernanke (inflation) or the market (deflation) we should worry about. My money is still on Bernanke for the current round.