Wednesday, December 19, 2007

Kudlow 101: Milton Friedman Rides Again

There are fresh signs that we are on the verge of a major inflationary plunge.

We recently took a closer look at the relationship between M1 and inflation. Here’s what we found. Since the early 1990s this relationship has improved dramatically. And over the last six years or so, this correlation has remained strong. This surprised me. I hadn’t looked at this in a long time. There is a clear link to prices and a plunging future inflation rate. This is classic Friedman monetarism.

Take a look at this picture of the CPI inflation rate:

Contrary to the recent flare-up of inflation last week, we are actually going to get a somewhat lower inflation rate this year of around 2.7 percent. Inflation was running at 3.2 percent in 2006 and 3.4 percent in 2005. So even though we had a bad number in November, calendar year-to-date, it’s actually lower than the prior two years.

Now let’s take a look at the M1 money supply. M1 is simply currency in circulation plus other checkable deposits. Milton Friedman used this. And it also happens to be part of the reason why inflation is coming down.

In the beginning of this decade, M1 was rising rather rapidly. It came in at 3.3 percent back in 2001, rose again the following year, and eventually peaked at 6.5 percent in 2003. But it has been coming down ever since. In fact, M1 came in at 2.0 percent in 2005, 0.2 percent in 2006, and calendar year-to-date, it’s actually in negative territory at minus 0.3 percent.

Money is the ultimate cause of inflation. Inflation is everywhere a monetary phenomenon. Therefore, since M1 growth has essentially collapsed, we are now looking at a big drop in CPI inflation.

Take a close look at this chart. With a two-year time lag, we’re looking at a roughly 1.5 percent inflation rate. Maybe even less.

As University of Michigan economist and Carpe Diem blogger Mark Perry told me, this relationship is not a direct, one-to-one relationship. In other words, there is about a 2 or 3-year lag, since money growth takes this amount of time before it has its final impact on prices.

There is no perfect, silver-bullet, forecasting device for inflation. And while this monetarist model revived by Mark Perry is interesting and statistically significant, no one can say for sure that this is the ultimate method of predicting inflation. That said, money still looks tight from the standpoint of an inverted yield curve and a near zero growth of the monetary base.

If these views are correct, now is the time to sell gold and buy the dollar.

Tomorrow we’ll take a look at the velocity (or turnover rate) of money and compare that to gold in the context of this monetary approach. Monetarist models of inflation have had their ups and downs over last 30 years, but so have commodity models of inflation. The trick is to use some common sense to evaluate the whole story.

But the key point here is that inflation looks like it’s going to plunge.