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I get a sense that the investment world has begun to discount the possibility of a significant increase in inflation over the next 1-3 years.  I think it’s a pretty big mistake.  The housing market appears to have bottomed out and with that, loan demand should start increasing.  With a down housing market no longer dragging loan demand to the floor, what’s left to hold back inflation?

The US Federal government continues to create a massive amount of new money each year with large budget deficits.  These act as a fiscal stimulus that has been roughly around 8% – 10% of GDP over the past few years.  That’s a lot of new money!

Federal Reserve policies are loose.  That wasn’t really much of a problem with a weak housing market dragging down loan demand, but now that housing is rebounding, I’d worry a bit  more about this.  The Feds totally ignored the last bubble, which started around 1998 and was exacerbated greatly by Fed policies in 2001 and 2002.  What actually worries me more isn’t the “loose Fed policies” so much as the dedication to keep those policies loose until certain (perhaps unreasonable) conditions are met, such as 6.5% unemployment.

So based on all of this, I’ve become more concerned about rising inflation.  I’ve been watching a few key indicators over the past several months.   M2 money supply is among them.   I feel like our high M2 money supply growth rate is being virtually ignored by the investment community right now, which is a mistake.

Here are the latest figures.  The chart below shows the year-over-year M2 growth rate.

M2 Money Supply Dec 2012

Might not look too meaningful at first glance, but notice we’re back at the levels seen during the bubble years and the early to mid 80’s.  What’s particularly notable about this is that the late 90’s bubble years were marked by higher nominal GDP growth, whereas the current environment is not; which would suggest that having a 6% – 10% M2 growth rate is a much bigger problem now than in 1998, for instance.

If that charts seems too spikey to get a handle on, here’s a rolling 3-year average of M2 money supply, which might be more meaningful.

M2 Money Supply Dec 2012 - 2

This chart looks even uglier than the first.  Once we start to level out some of the spikes, we begin to see that the sustained long-term M2 money supply growth rate right now is actually at one of the highest points in the past 25 years.  We have a 3-yr average of 5.9%, which is on par with the 6.3% peak in 2001.  Except, once again, only without the economic growth of that era.

These figures, as well as the US’s massive budget deficits and the Fed’s new-found dedication to permanently loose monetary policy are frightening.  I wouldn’t overreact — many commentators over the past few years have warned of hyperinflation, but that’s extremely unlikely.

In actuality, with the way our system works, what’s more likely is that inflation spikes, which then forces the Feds to suddenly raise interest rates, creating a new recession.  But regardless, none of this is beneficial and I would not  be shocked to see a return to the up-and-down stagflationary markets of the 1970’s.