Let me paraphrase Milton Friedman: “Inflation may be a monetary phenomenon, but money is only inflationary if it gets spent quickly.”
The St. Louis Fed in a just-released analysis shows that the very important “money velocity” indicator, the quarterly GDP/M2 ratio, for the fourth quarter of 2008 actually has fallen to its lowest level since the same quarter in 1991 in Q4 2008.
As long as the money velocity doesn’t pick up abruptly, investors shouldn’t worry that much about inflation. But, be sure, we’ll see inflation again.
That said, it’s important to zoom in on the sudden and important rise, since March 9, of the euro against the dollar, particularly since it has been rising on a trade-weighted basis.
We all have noted the euro has shown a close relationship with the price of gold.
The European Central Bank’s growing hard-line reputation under Jean-Claude Trichet became clear through the course of 2004 and 2005. Then, when we saw a first great inflation fear when Hurricane Katrina hit, it seemed that euro appeared following gold almost tick for tick as an inflation hedge.
Noteworthy was the daily correlation between the euro-dollar and gold-dollar pairs between the start of 2006 and the end of 2008, averaging an impressive 91 percent.
Since January 16, 2009, this correlation changed abruptly, to negative 49 percent, following Standard and Poor's downgrade of the sovereign debt of a number of Eurozone members.
We saw a sharp widening in intra-European government bond yield spreads but also a damaging rise in the cost of credit-default swaps. Serious concerns were mounting over nations such Ireland as well as the exposure of the Western European banking system to Eastern and Central Europe.
To investors, it had become clear that the No. 1 priority was to provide some form of assurance rather than worry about the Holy Grail — stability for the euro.
By mid-February, the credit-default swap on Germany’s sovereign debt began to rise quickly relative to those on its European neighbors that, understandably, triggered a rapid loss of faith in the euro as a store of value.
Between Jan. 16 and March 9 the negative correlation between euro-dollar and gold-dollar pairs reached 66 percent.
Then, on March 9th, there was that “Eurogroup” meeting and it now appears that precisely on that date investor perceptions have changed practically overnight on the euro, as it became clear that the European finance ministers had little interest in supporting U.S. calls for another global fiscal stimulus plan.
At the conclusion of that meeting, Chairman Jean-Claude Juencker stated that “the 16 finance ministers agreed that recent American appeals insisting Europeans make an added budgetary effort were not to our liking.”
This reticent attitude was re-emphasized by Bundesbank President Axel Weber, who said: “We have reached our limits. The expectation that we could neutralize this ¬synchronized recession through short-term fiscal policy measures is false. We should not even try. There will be costs.”
Bottom line: The euro seems to have regained, suddenly, some of its earlier “store value” status.
But, as Napoleon’s mother said: “Pourvu que ca dure." (If it only lasts.)
EU leaders have drafted a proposal to be presented at April's G20 summit in London will which call for “a doubling of IMF resources so that the Fund can help its members swiftly and flexibly if they experience balance of payment difficulties.”
It made no reference to the size of the possible EU contribution to any doubling. EU officials said they would make a contribution of $75 billion, but wanted to consult first with other Group of 20 countries.
Bank of England chief economist Spencer Dale told the Financial Times: “A substantial amount of the total contraction we're going to see has come through,” noting that the economy will begin growing again by the end of the year and expand at normal rates throughout 2010.
Dale cites loose monetary policy as one explanation behind his view but notes that if ever there was a sign of inflation taking off, quantitative easing would be withdrawn and the bank would be “equally as bold and decisive as when we're putting it in.”
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