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Inflation is always and everywhere a monetary phenomenon - Milton Friedman

When, as has occurred in the US, high powered money quadrupled over 5 years, while GDP rose by only 25% during the same period, one can only imagine the inflationary impact this could have once money velocity reverses its contracting pace and begins to accelerate.

Of course, we are fully aware of the consensus thinking saying that despite all the money printing since 2008, inflation has not yet kicked-in meaningfully, let alone hyperinflation. But just because prices have not gone up yet, doesn't mean it will never happen. Actually, with each passing week the chances of an inflation kick-off increase, and with current inflation expectation pricing models pointing more towards the deflation side, the moment of truth might be closer than most investors anticipate (contrarian view).

Actually, to all those investors who still believe deflation is a greater threat than inflation, we reiterate the Fed’s main argument behind the various quantitative easing initiatives since 2008: preventing deflation. Despite all the initiatives and programs, if prices fall back below 1% as measured by the Fed’s own inflation indicator (PCE), then investors should be prepared for an increase in the Fed’s monthly asset purchasing program, which currently sits at around USD 85 billion per month. In other words, the US central bank won’t give up on its mission to lift prices to their defined level of “price stability” of 2.0 - 2.5%. Therefore, the focus of all financial market participants should be on “when” as opposed to “if” inflation kicks in …Investors might consider preparing a framework to help detect the early acceleration of prices. Among indicators, balance sheet expansion by the banks relative to newly printed Fed money could be a helpful and leading guide. Also, a falling US dollar might pre-indicate changing price expectations. But ultimately, increasing inflation figures (CPI, PCE etc.) will deliver hard evidence of rising prices.

Now, let’s list three quantitative tightening tools the US central bank could implement should its PCE accelerate beyond 2.5%, and let’s also discuss the possible impacts on financial markets. (Remarks by the Fed chairman, Bernanke, that his central bank could also strengthen its balance sheet by letting various bonds mature will not be discussed here as such a strategy could take years to normalize the Fed balance sheet given its sheer size, and this could hardly be labeled a decisive and determined approach).....


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