Bond markets moved sharply lower this week on fears that central bankers around the world are planning a crackdown on inflation. Increases in interest rates in the US, the UK and the euro zone now expected. Apparently the shift came after Ben Bernanke warned of growing inflationary pressures. Investors would not have been so surprised at seeing price inflation if they had not been so confused about the nature of inflation in the first place.

On Tuesday Ben Bernanke said that he still doesn’t see evidence of rising inflation expectations. Even though one could be forgiven for thinking that he was joking, given the dramatic rise in food and energy prices, he wasn’t. But what do “inflation expectations” have to do with inflation? It depends on whom you ask.

In my simple way of understanding the world, inflation is a monetary phenomenon. If you increase (inflate) the amount of money then prices will increase by exactly the same proportion assuming no change in productivity, economic output, or the population. But nowadays economists are much smarter -- they no longer believe that an increase in the money supply is inflation, or causes prices to rise. No, today they believe that inflation is an increase in prices. In other words, they have conveniently defined away the cause of price inflation so that inflation is deemed to be an increase in prices and not the result of an increase in the supply of money.

But there is still the nagging suspicion that an increase in prices ought to have a cause. To solve this, modern economists (and especially those working for central banks) seem to think that consumers’ expectations determine inflation. It works like this: if consumers expect prices to rise then they will ask for more wages and the increase in wages will cause prices to rise. So the whole trick is to “anchor” consumers’ expectations. This may seem absurd, and it is, but it is also what determines monetary policy today in places like the US, the UK and Europe. Take a look at the following quotes:

The first quote is from Ben Bernanke, the current chairman of the Board of Directors of the Federal Reserve Bank of the United States (link): “Today I will offer a few remarks on the relationships among monetary policy, inflation, and the public's expectations of inflation…”

“Undoubtedly, the state of inflation expectations greatly influences actual inflation and thus the central bank's ability to achieve price stability. But what do we mean, precisely, by "the state of inflation expectations"? How should we measure inflation expectations, and how should we use that information for forecasting and controlling inflation?”

“…long-run inflation expectations do vary over time. That is, they are not perfectly anchored in real economies; moreover, the extent to which they are anchored can change, depending on economic developments and (most important) the current and past conduct of monetary policy. In this context, I use the term "anchored" to mean relatively insensitive to incoming data. So, for example, if the public experiences a spell of inflation higher than their long-run expectation, but their long-run expectation of inflation changes little as a result, then inflation expectations are well anchored. If, on the other hand, the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.”

This totally absurd line of thinking is what sets US monetary policy today. Such a line of reasoning is not just entirely flawed, but so bizarre that I actually find it difficult to write about it. One can disprove it merely by noticing that consumers did not expect price inflation to increase last year, and yet it has, even though wages have not increased correspondingly.

It’s not just the US that’s suffering from this delusion. The following quote is from a news conference on June 5th, 2008, from Jean-Claude Trichet, the president of the European Central Bank (link): “It is imperative to secure that medium- to longer-term inflation expectations remain firmly anchored in line with price stability.”

At an Economic and Monetary Affairs Committee of the European Parliament in Brussels on March 21, 2007, Trichet had this to say (link): “Of course, keeping our interest rate at an unprecedented low level for two years and a half would not have been part of a feasible policy, without consistent signs that expectations were well-anchored and the inflationary shocks that were hitting the economy at the time of the downturn were being quickly reabsorbed.”

Unfortunately by keeping interest rates at unprecedented low levels the demand for credit caused the supply of money to increase. Prices are increasing as a result, and “somehow” inflation expectations are unhinging -- what as surprise!

I could keep on quoting central bankers talking about inflation expectations and fretting about whether they are well anchored or not but I think the point has been driven home: while central bankers have diverted attention from the cause of price increases they have not been able to annul the law of supply and demand, which dictates that if the supply of money increases without an offsetting increase in demand then the price (value) of money will fall resulting in an increase in the prices of goods and services in terms of money.

Regardless of how they try to talk away the effects of increasing the money supply the simple truth is that when the supply of money increases the value of money decreases and therefore prices of goods and services go up. Gold is most sensitive to the increase in the money supply because gold itself is money. Oil is perhaps second most sensitive as it is one of the most important commodities of our modern society. While the government statisticians can modify the consumer price index with hedonic adjustments and geometric averaging, neither gold nor oil have undergone “quality improvements” during the past twenty years, nor are there suitable substitutes available for them, which is why their prices more accurately reflect the true levels of monetary inflation and money’s debasement than the official consumer price index.

Central bankers have been able to convolute the discussion of money and inflation to such an extent that they no longer know how to define money, never mind measure the increase in money supply (What is money?).

I have until now used M3 as a measure of the increase in the money supply and it has worked very well in the models I use. However, recently I have given the concept of money considerable thought and I believe I have an even better measure of the increase in money supply (and it’s not TMS).

I need to do some more testing on this and will then update my gold price model accordingly. I am currently in Vancouver (for Cambridge House’s investment conference) and will only be back at my office on Thursday, and because working on a new model for the gold price is a high priority right now I am not going to write a letter next week. Instead, I hope to have a new gold price model for you the following week, i.e. by Friday the 27th.

A quick comment on gold: talk of intervention in currency markets to prop up the dollar has finally gained momentum. You’ll recall that I anticipated such intervention earlier this year and suggested the gold price could decline as a result. However, I think it might be a case of too little too late. We will soon find out. If the gold price remains above $850 then I think the threat of intervention came too late for the dollar; however, if the threat of intervention is successful in pushing the dollar higher and gold falls below $850 then we may have some more downside in the near term. Keep an eye on $850.

I also expected interest rates to rise and bond prices to fall, and they have. Being short US Treasuries has certainly paid off thus far (Soaring interest rates).

During the past ten years I have talked ad nauseam about the dollar exchange rate, the fact that it would decline, and the impact that would have on the gold price. Going forward I can see the dollar’s exchange rate remaining important, but taking a back seat to a discussion of money and inflation. It is the nature of money and its value, or lack thereof, that I feel is going to be most important during the next ten years. Without a sold grasp of money and inflation very little is going to make any sense.