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Some Information For People That Dont Know.

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Inflation is always and everywhere a monetary phenomenon.

— Milton Friedman

Inflation, as defined in Economics 101, is the increase in the supply of available money and credit relative to the available goods and services, resulting in rising general prices. Adam Hamilton's lucid explanation on inflation explains this better: "Imagine that everything for sale on the entire planet, every good or service in existence today, is quantifiable in 100 units. Also, imagine that all the money in the world is also equal to 100 units today. Then assume that by the end of year, the absolute available goods and services on the planet will have increased to 102 units for a respectable gain of 2 per cent real gain in world GDP.

"If, over the same period of time, the global money supply increased to 112 units (up 12 per cent), then with 112 units chasing only 102 units of goods and services, global price levels would gradually rise. This is obviously so because there are only a finite number of things on which money can be spent and, therefore, an increase in the money supply which exceeds the increase in available goods and services over the same time period tends to be inflationary."

The other factor that influences price levels is `money velocity', which measures the volume of purchases relative to the supply of money. So, `price level' can be defined as Money Supply x Money Velocity / Supply of Real Goods.

Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services. This helps investors gauge how robust the economy is. It is usually measured as a ratio of GNP to a country's total supply of money.

That said, the velocity of money is relatively stable till the terminal stages of an inflationary cycle; for the early stages, as we are in now, money supply is a far more important variable.

With the Indian economy seemingly following the US Federal Reserve in following a tight money policy, it may be useful to look at the Fed's experiences and responses in taking on inflation.

The thinking that inflation is linked to money supply was well understood in the 1980s, in part because of the experience of the 1970s. However, under the former US Fed chief, Mr Alan Greenspan, the focus shifted from money supply to price inflation from the measurement of causes to measurement of effects.

US Money Supply

Money supply has varying measures and it is generally agreed that M3 is the broadest. M3 is the sum total of all physical currency (M0) + amount in all demand accounts (M1) + amount in savings account, money market accounts and CDs under certain limits (M2) + all other CDs and repos.

Under `The Maestro', Mr Alan Greenspan, the M3 has increased from $3.5 trillion in 1987 to $10.4 trillion in 2005. From 1994, M3 has grown at nearly 8 per cent — more than twice the rate of the US' GDP growth.

The main reasons why this did not result in price inflation are:

Not all price increases are viewed as "inflationary". For example, an increase in asset prices — that is, financial assets (stocks and bonds) and real estate. It is only when this increased money supply finds its outlet in commodities that consumers witness price inflation.

There is another outlet for inflation — rising trade deficits. The US has been able to import a lot of cheap goods and services from China and India that kept the price levels in check. While a rising trade deficit would normally lead to a falling currency, the dollar has been relatively unscathed due to its status as the world's reserve currency.

Even so, the inflation, as reported by the US Fed, is highly questionable. Investment gurus Jim Rogers and Bill Gross term it "manipulation", as reported inflation is subject to the following adjustments:

Hedonic Adjustments: That's an adjustment to price levels to account for the quality improvements. Reports of the Bureau of Labour Statistics indicate that nearly 46 per cent of the items that go into calculating inflation are subject to hedonic adjustments.

Geometric Weighting and Substitution: The weightage associated with different items is changed over a period of time with a much higher weightage given to "New Economy" items such as computers, television and cell phones.

These items, due to their early stage product lifecycles, show a declining price trend and this reduces the reported inflation numbers.

Core Rate: When the above measures are ineffective, the Fed resorts to reporting the core rate, which is inflation excluding food and energy — the two most important components of the recent commodity bull run.

Outlook for interest rates

In some ways, the present situation is very similar to the one witnessed during the 1970s, and so studying what happened then would be useful.

Similar to the 1990s, money supply increased during the 1970s, far in excess of GDP growth rates. Total outstanding M3 from 1970 to 1981 increased from $685 billion to $2.2 trillion. So, throughout the 1970s, when the Fed kept increasing interest rates (supposedly to check inflation), it was also pumping money into the system, with the result that commodity prices continued to increase.

Similarly, by the time this cycle ends in the US, interest rates may well be in double digits. There is another factor that could lead to even higher interest rates than the earlier cycles, and that is the record US current account deficit, at 6 per cent of GDP. So far, the foreign central banks have been happy to buy US Treasuries, and that has prevented the full inflationary effects of the deficit from materialising. If these central banks stop buying, the US would be forced to monetise the debt, which would increase the money supply further.

`Inflation target'

Notwithstanding his goal of having an "Inflation Target", the Fed chief, Mr Ben Bernanke, has made it obvious that he would be willing to drop dollar bills from a helicopter if the situation warrants. So, given a problem (a housing bubble collapse, for instance), the chances are that there would be a loosening of purse strings.

Pointing to this direction is the action by the Fed of discontinuing reporting M3 effective February 2006, supposedly because the "costs of calculating M3 are high". It was indeed surprising that Wall Street and other central bankers did not make this an issue.

The situation today can best be summarised by quoting from Jens O. Parsson's book Dying of Money. He states: "Everyone loves an early inflation. The effects at the beginning of inflation are all good. There is steepened money expansion, rising government spending, increased government budget deficits, booming stock markets, and spectacular general prosperity, all in the midst of temporarily stable prices. Everyone benefits, and no one pays. That is the early part of the cycle.

"In the later inflation, on the other hand, the effects are all bad. The government may steadily increase the money inflation in order to stave off the latter effects, but the latter effects patiently wait. In terminal inflation, there is faltering prosperity, tightness of money, falling stock markets, rising taxes, still larger government deficits, and roaring money expansion, now accompanied by soaring prices and ineffectiveness of all the traditional remedies. Everyone pays and no one benefits. That is the full cycle of every inflation." Mr Greenspan enjoyed the early benefits. Mr Bernanke, it seems, will be forced to bear the brunt.

Edited by crash2006

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