Hennessee warns of crisis of inflation on the horizon as money supply soars

Date: Monday, November 17, 2008
Author: Hedgeweek.com

Hennessee Group, an adviser to hedge fund investors, says it is warning its clients that while the US Federal Reserve and Treasury are taking the necessary action to remedy the credit crisis and mitigate the risk of the worst recession in history, these actions are setting the stage for a period of high inflation within the next three years.

'A hyperinflationary period could be the next crisis on the horizon beginning in 2010 or 2011,' says the firm's co-founder Charles Gradante. 'If the money supply continues to grow at its current pace, we could see inflationary levels similar to those experienced in the 1970s once the credit crisis begins to subside.' He believes M2 money supply growth will exceed 12 per cent in 2009, rivalling its level in the 1970s.

Inflation peaked at 12 per cent in 1974 and 13 per cent in 1979, which is widely attributed largely to oil price shocks (petroleum rose from USD3 a barrel in 1970 to USD40 in 1980) and the budget deficit of the Vietnam War era.

However, Hennessee Group believes that the Fed's easy money and credit policies served as the primary drivers for igniting inflation. Money supply growth peaked at an annualised rate of 12 per cent in both 1972 and 1977, due in large part to a government priority of maintaining low levels of unemployment rather than keeping inflation in check.

The monetary policies of the 1970s led to extremely high levels of inflation, forcing the Fed quickly to raise interest rates in order to curb money supply growth. Interest rates that reached 20 per cent in 1980 contributed to the 1981-82 recession, Hennessee says, arguing that monetary policy first led the U.S. into an environment of high inflation and then one of stagflation, where the economy experiences both rising prices and sluggish growth.

In the 1970s, equities suffered one of the worst bear markets in history, with the Dow Jones Industrial Average losing nearly half its value from 1973 to 1974. The most notable hedge against inflation was gold, which rose from USD106 in 1976 to USD850 by 1980, equivalent to more than USD2,000 in 2008 dollars on an inflation adjusted basis.

Other precious metals soared, including platinum (USD90 in 1970 to more than USD1,000 a decade later) and silver (from USD2 to USD50 in 1980). Among non-precious metals, copper rose from 53 cents in 1970 to 89 cents in 1980, having reached USD1.06 in 1979. Agricultural commodities also experienced significant increases, with wheat tripling in price.

The Hennessee Group fears the US could end up in a similar scenario if the Fed and Treasury do 'whatever it takes' to avoid further fallout from the credit crisis, although Gradante says the firm strongly agrees with former Federal Reserve chairman Paul Volcker, who recently said: 'The first priority is to stabilise the financial system ... even though the cost involved is heavy government intrusion in markets that should be private. It's not going to be a problem in the short run. Inflation doesn't flourish in the face of recession. It's something we have to worry about when we get out of this recession.'

While there has been a recent fall in the price of oil and other commodities, as well as in inflation in general, the Hennessee Group believes this is a short-term correction in a longer term upward trend in inflation, which could be exacerbated by the recent aggressive fiscal and monetary stimuli in the form of lower interest rates and the injection of aggressively lowered interest rates in recent months and has injected a tremendous amount of liquidity into the marketplace through the USD700bn Troubled Asset Relief Program and the Commercial Paper Funding Facility.

As a result of these actions and several others, the money supply has been growing at an increasing rate in recent months. In total, the US has lent out nearly USD1trn in bailout money and some estimates say this could reach USD2trn before the crisis comes to an end.

Based on these estimates, the Hennessee Group believes M2 money supply could reach USD8.6 trillion between June and August 2009, which would mean year-on-year growth of some 13 per cent from USD7.6trn in June this year.

'Such a scenario could ultimately force the Fed to reverse course in monetary policy as it did in the late 1970s by aggressively raising rates and removing liquidity from the marketplace,' Gradante says. 'As a possible consequence of these actions, the US could experience the worst of all economic conditions, stagflation.' Against this backdrop, the Hennessee Group believes commodities such as gold and other precious metals could serve as good hedges against inflation, as they did in the 1970s.