The real threat of inflation, decreasing foreign reserves: Why the US should expect 8% inflation for the next three years

Weekly we put out information on the US Dollar Money supply.  Current M2 money supply is over 9 Trillion dollars. 

Source: Federal Reserve

This is a good proxy for money growth and good predictor of inflation except for one crucial flaw. 

There is some money which is printed, but does not make it into the money supply.  Consider the scenario that the Fed prints a dollar that is then either lost or destroyed.  It then cannot be used to buy goods, or be lent out and thus does not create inflation. 

There is something else which can happen to our money which has the same net effect.  Foreign central banks can take cash printed from the Fed and place it on their balance sheet.  US dollars on foreign banks balance sheets gives investors confidence that their own currency will not be debased. 

In our current (weakening) dollar regime, the US dollar is the main foreign reserve currency.  When foreign central banks put US dollars onto their balance sheet, they take them out of circulation.  They are not being used to buy goods.  These dollars are not lent out.  As such, they do not create inflation.  

10 year USD/EUR
Americans have benefitted greatly from having central banks prefer our cash to even their own.  It has allowed the Fed to print money like mad without the fear of inflation.  

In other words, the real threat of inflation is not the current printing of money which Bernanke et al have been doing.  It is the previous printing of money which has been taken out of circulation.  The threat is as great as its ever been.  The amount of money in foreign reserves is about one third or more of M2, or every dollar which is held by US bank account (business or retail), and all currency combined.
There are signs that this dollar regime will be ending.  The cracks have been apparent for some time, but we just blew a big hole in the US Dollar dam.  This week, China has announced that they will reduce their US dollar holdings by more than 1.7 Trillion Dollars. Via Xinhuanet:

The amount of foreign exchange reserves should be restricted to between 800 billion to 1.3 trillion U.S. dollars, Tang told a forum in Beijing, saying that the current reserve amount is too high.

China's foreign exchange reserves increased by 197.4 billion U.S. dollars in the first three months of this year to 3.04 trillion U.S. dollars by the end of March.
1.7 Trillion dollars  is the amount that we have added to our money supply since August 2007.  If all that money were to come into the current US money supply all at once it would increase money supply by 19%.  That would make US inflation among the highest in the world. 

Source:  SIFMA

If this action were to be followed by other central banks in Japan or Europe, there would be a real danger of hyperinflation to the tune of 50%. 

Now, odds are they won't do this all at once.  That is why we have said that at least the amount of inflation, should it be spread out over 3 years should be 8% or more.

See the total allocated and unallocated foreign reserves above.  You can see that the US Dollar, is the king right now, but the Euro is gaining.  What is gaining even faster is the Unallocated foreign reserves, which means it is either in something else (gold, or IMF certificates), or they don't want to disclose. 

Either way, it should be concerning to anyone who has money in dollars... very concerning. 


  1. Not accurate. When the PBOC buys Treasuries, they pay by depositing funds in the U.S. dollar bank account of the seller. These accounts form part of M2 and are available to be spent. They are not taken out of circulation.

  2. Actually, I believe that China is putting money back into circulation buy lending to the US government through the purchase of treausuries. If China decides to sell the bonds (or decides to not roll them over at maturity), then it would mop up liquidity.

    So I believe it's exactly the opposite. China has not being sitting on cash, but it gave that cash back to the US via government bond purchases.

  3. BTW, the only way to take dollars out of circulation is to stuff them in a mattress or place them on deposit at the Fed (as Excess Reserves). Otherwise, they will find themselves being deposited in someone's bank account (or spent as cash), in which case they are "circulating".

  4. Jeezus! If it were to rain all at once in one place that place would probably get a hundred-thousand feet of rain!

    That would be a record!

    Why would central bankers shoot themselves in the foot?

  5. Thanks for your comments.

    @ anonymous. @ tito costa.

    You are right. Your comments are appreciated. Thanks for disabusing me of this. Maybe not a spike in inflation, but yes a spike in interest rates as yields would jump.

    @ Steve ha ha. The effect of mass hysteria cannot be overlooked.

  6. Interesting read and comments. I was wondering how China would embark on this campaign. No one wants to be the last person standing in a game of musical chairs and it seems like the US is going to be the one standing no matter what.

  7. @ anonymous. Whether it is cash or treasury notes it is the same thing. When the fed prints debt, that takes money out of the system and M2.

    Having that money in China, wether as notes or cash doesn't matter. The reason is simple. They don't pay people, they pay the Fed.


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