The Trail of Inflation: Follow the Money

All the President’s Men (the 1976 movie about Watergate) made the phrase ‘follow the money’ part of our lexicon.

If you want to find out where the trail leads, follow the money.

Today, we are on the trail of inflation.

Central banks have tried (and boy how they have tried) to track down the elusive inflation.

Prior to the GFC, US inflation sat comfortably in the 2–4% range.

After 2010, it found a new level between zero and 2%:

Port Phillip Publishing

Source: Trading Economics

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Why is that?

After the 2001 recession, Greenspan dropped US rates (red line to right-hand scale) like a stone, going from 6% to 1%.

During the initial stages of low interest rates, the US savings rate (blue line to left-hand scale) stayed above the 5% level.

But then something odd happened. As Greenspan raised rates, people saved less. You’d think getting more interest in the bank would lead to a higher level of savings.

Not so.

Port Phillip Publishing

Source: Federal Reserve Economic Data

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The US housing boom.

People start thinking ‘Which do I choose, 4–5% in the bank OR a quick $100k on a house flip?’

When there’s universal belief in an opportunity to outperform the bank rate, people will go for it.

All that extra money coming into the system after 2004, is why the US inflation rate moved into the 3–5% range.

Then the US housing bubble met its pin.

The dynamics changed.

Bernanke took rates (red line) into the cellar and (followed by Yellen) kept them there for a very long time.

Savers were being shafted.

Yet, look at the savings rate (blue line). It remained persistently around the 7% level…a far cry from its 2005 low of 2%.

Port Phillip Publishing

Source: Federal Reserve Economic Data

[Click to open in a new window]

The difference a decade makes…

Port Phillip Publishing

Central banks believe that by lowering interest rates they’ll create inflation. Clearly that does not work.

Inflation was higher in the US when interest rates were at 4%.

The difference in the two situations is the savings rate.

The Fed can dangle the ‘look how cheap it is to borrow and satisfy that consumption craving’ carrot, but if the community at large decides to show some restraint, the money stays in the bank and the CPI needle remains low.

After the initial post-GFC spike, CPI settled in below the ‘picked out the air’ central bank inflation target of 2%.

So what was the next lever the Fed pulled?

Create more money. How much more? Trillions.

M2 money stock (red line to left-hand scale) in 2008 was US$8 trillion. To put this amount into perspective, the Fed was legislated into existence in 1913. It took almost a century to create this US$8 trillion.

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Since 2008, US M2 money stock has increased to US$19 trillion, an additional US$11 trillion in the space of 12 years.

Port Phillip Publishing

Source: Federal Reserve Economic Data

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Zero-bound rates plus an additional US$12 trillion must surely equal higher inflation.

Close…but no cigar.

Port Phillip Publishing

Source: US Bureau of Labor Statistics

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Over the past 12 months, US CPI has averaged 1.4% below the coveted target of 2%.

The blue line (to the right-hand scale) in the above chart is the velocity of money. This is the rate at which all that M2 money stock moves through the US economy.

Back in 2000, a US dollar went through the hands more than twice a year. US CPI back in 2000 was knocking on 4%.

While people are prepared to open their wallets or purses more frequently, then suppliers can afford to lift prices.

But look at what’s happened with the velocity of money over the past two decades…the trend is down.

These days — even with all that newly created money in the system — a dollar is only being passed around at the rate of once a year.

Wallets and purses are being opened less frequently.

The money goes to the banks

Where’s all that new money sitting?

A good chunk of it is in the banks.


The Fed can print the money, but under its charter cannot spend it. The money goes to the banks.

Banks are reluctant to lend for fear any new borrowings may not be repaid. And customers are equally as reluctant to borrow for fear they may not be able to repay the debt.

Therefore, the money stockpiles. Which is why there’s a spike in the savings rate.

When you follow the money, you see that printing money and ultra-low rates do not automatically lead to higher inflation.

It takes a never-ending conga line of willing borrowers and lenders to get (and sustain) the inflation rate above the targeted level.

Inflation is locked inside the bank vaults and consumer wallets and purses. As long as they remain more closed than open, inflation is contained.

If you want to follow the money, then keep a close eye on the velocity of M2. This will tell you whether inflation remains confined or has been set free.

And if inflation remains confined, don’t be surprised if the Fed deems it essential to violate its charter and become a spender in its own right.

Should that happen, then you can be assured the money path will lead to much higher inflation.

With the buying power of savings being decimated, dollars will start passing through people’s hands at an accelerated rate.

Trying to contain that will then become a major problem for central banks. But this hypothetical scenario only eventuates if the Fed decides to dispense with the pretence of being a prudent steward of the economy.

For now and the foreseeable future, it looks like we’re going to have persistently low inflation.


Vern Gowdie Signature

Vern Gowdie,
Editor, The Rum Rebellion

Vern has been involved in financial planning since 1986.

In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognised in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

In 2005, Vern commenced his writing career with the ‘Big Picture’ column for regional newspapers and was a commentator on financial matters for Prime Radio talkback.

In 2008, he sold his financial planning firm due to concerns about an impending economic downturn and the impact this would have on the investment industry.

In 2013, he joined Fat Tail Investment Research as editor of Gowdie Family Wealth. In 2015, his book The End of Australia sold over 20,000 copies and launched his second premium newsletter, The Gowdie Letter.

Vern has since published two other books, A Parents Gift of Knowledge, all about the passing of investing intelligence from father to daughter, and How Much Bull can Investors Bear, an expose on the investment industry’s smoke and mirrors.

His contrarian views often place him at odds with the financial planning profession today, but Vern’s sole motivation is to help investors like you to protect their own and their family’s wealth.

Vern is Founder and Chairman of The Gowdie Advisory and The Gowdie Letter advisory service.

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