Deflation or inflation?

With much of the focus in the commodities sector on crude oil and the precious metals gold and silver, what's been somewhat lost among the mainstream media and audience is the surge in the "red" metal, copper. Since copper is used in many industrial, housing, and information technology industries, it's been dubbed the bellweather for economic activity and inflation.

http://stockcharts.com/h-sc/ui

The deflationists correctly claim economic activity is dormant in the US and other developed countries, but they are not accounting for the unintended consequences of the carry trade, where Fed easy monetary and interest rate policies are causing asset bubbles and booming economic activity in emerging countries such as China, India, and Brazil. In essence, the hot money is borrowing at 0% interest rates in the USDollar, and investing in commodities and equities in foreign currencies, hence driving asset values higher.

Deflationists also point to official consumer price index (CPI) numbers--benignly low at 0.1% in November, 2009, as further proof that inflation is not an imminent threat.

To which I say "hogwash", as the increase in copper and commodities prices overall reflect inflationary pressures. Banking lending has not returned to nominal levels and wage labor prices have not increased due to a loose employment market; these two scenarios should be keeping a lid on prices. But commodities prices continue to rise despite an absence of these two inflationary factors. When and if the two components do return, inflation could potentially soar due to the exploding monetary base and resultant increased money supply.

While I expect asset values in US housing and equities in certain sectors to continue to be under pressure, the Fed's easy money policies will continue to debase the USDollar, deteriorating the purchasing power of consumers.

A quick primer on inflation

According to monetary theorists, inflation or deflation is created through the easing or tightening of our money supply, respectively. The Federal Reserve Bank controls our money supply, so its monetary policies ultimately determine the rate of inflation.

Here is the St. Louis Federal Reserve Bank's chart on monetary velocity:

http://research.stlouisfed.org/publications/mt/page12.pdf

The empirical formula is m x v = p x q, where
m = money supply
v = velocity of money
p = price level
q = level of economic activity

Looking at the two charts above, we can see money supply growth has been astronomical since 2008, while monetary velocity has remained moribund. The financial crisis has depressed economic activity due to lack of money velocity, i.e. banks aren't lending as they recapitalize their broken balance sheets. Velocity of money is the only fuse to stoke the fire of inflation. And when it does, look out. The other components are already in place for soaring prices.