By Irene Aldridge
Over the past three years, much of the online and cocktail party chatter has buzzed around the when to expect inflation. Everyone has long agreed that high inflation is inevitable, gold ETFs have been snapped up and prices driven to the sky by hedgers, yet month after month the level of inflation remains precariously low. According to the quantitative determinants of inflation the Fed adjusts money supply in response to oil prices, as such, with rising oil prices we can expect the Fed to take measures to reduce inflation expectations.
Inflation is a function of many variables, with the amount of money put into circulation by the Federal Reserve ranking high in its importance. In fact, a quantitative analysis shows that for every US$50 billion hike in the U.S. monthly money supply (an average change in money and its equivalents), annualized inflation rate increases by over half of a percent. The increase in inflation, however, does not happen instantaneously, but is delayed by two months.
Figure 1 shows the cumulative increase in the U.S. Money Supply enacted by the Fed over the past two years. As Figure 1 shows, there has been nearly half a trillion dollars pumped into the financial circulation over the past year alone. This rise may halt, however, as another factor is playing an important role in the Fedâ€™s determination of whether to keep the money faucets open: the price of oil.
Indeed, as the Fed Chairman Ben Bernanke has stated, high oil prices may hamper economic recovery. Combined with high inflation, high oil prices may bring the U.S. economy back to the brink of the recession. As another quantitative analysis shows, the Fed really means what it says: the money supply is inversely related to the oil prices observed in the previous month. Following a monthly rise in the oil prices, the Fed tends to cut down its money supply, keeping the lid on the inflation. With the current political uncertainty in the Middle East driving up prices on oil, it is likely that the inflation will just have to wait until the political situation in the oil-rich region stabilizes and oil prices go back to normal levels.
Irene Aldridge is a quantitative portfolio manager at ABLE Alpha Trading, LTD. She is also a co-author of the Quant Investorâ€™s Almanac 2011: A Roadmap to Investing (Wiley, 2010), an up-to-the-minute compendium of economic announcements upcoming in 2011, and a summary of responses of various equities, foreign exchange and other securities to different economic announcements.