- 2000: Volume 9, No. 4 Prices and the Prime

Back in the late 70s, there was a period of rampant price appreciation (hereafter "RISPRI", an acronym for rising prices) in commodities. Likewise, the price of money, the prime interest rate, was also rising. The RISPRI was due to the inflating of the supply of money substitutes. In the U.S., there is no money in circulation as defined legally; what is in circulation are money substitutes which act like and are used as money. (For more information on this topic, see my booklet America's Monetary Mess which is available at sarsoun@hotmail.com.) The inflating of the so-called money supply above and beyond any increase in productivity as measured by the GNP, or any increase in monetary reserves of gold and silver, is a cause and effect relationship which yields the bidding up of prices of goods and services. Unfortunately, the legislators and the press have these concepts confused and they erroneously call rising prices "inflation." We will, therefore, use the term "RISPRI" for rising prices, and "FALPRI" for falling prices. Inflation we will define as the increase in the supply of money or, in the case of the U.S., the increase in the supply of money substitutes.

During the 70s there was an increase in the money supply which caused RISPRI. To illustrate, let us say that the Congress of the United States decides to spend some money. Since they don't have any real money, they float a debt issue. The Federal Reserve takes the debt issue and credits the account of the U.S. The U.S. spends the credit into circulation by paying for the various and sundry expenses that are part of the appropriation. Congressman Phil Crane called this the "monetization of debt," an apt term. We are using debt for money. So contractors doing work for the government get checks, little old ladies get checks, all kinds of people get money from the government. Now when there has been no increase productivity or monetary reserves, this increase in paper chasing a static supply of goods and services will cause the prices of those goods and services to bid up, hence RISPRI. RISPRI is caused by the increase in money supply, the inflating supply of paper, but RISPRI is not inflation. RISPRI is an effect of inflating the money supply.

So prices were rising throughout the 70s as the paper currency increased in quantity. It is the law of supply and demand and it applies to money the same as it applies to corn or soybeans. Increase the supply of corn or beans in a static demand situation, and the price of corn and beans will go down. Increase the quantity of money without an increase in productivity or an increase in the monetary reserves, and the value of the money will decline. Prices are rising because the paper is losing its purchasing power value. The dollar (actually, the Federal Reserve Note currency; the real dollar is a silver coin) was also falling in value vis-à-vis the foreign currencies of the world.

When prices of goods rise, there is also another phenomena that takes place. The paper money that is declining in purchasing power value goes into the holding of commodities, especially gold and silver, as these are historic hedges against a depreciating currency. Capital that would otherwise be available for investment or lending is chasing after the purchase of real assets, things like the precious metals, wheat, pork bellies and other tangible goods. The lack of capital available to the debt markets forces the cost of money to rise, as witnessed by the rise in interest rates. In addition, the holders of this depreciating paper wish to be compensated for the decline in value that occurs while they hold the money. So a premium or surcharge is built into the cost of money and the more prices rise, the more these losers—these holders of the depreciating currency, these people who are losing out on the holding of the hedges—demand to be compensated for their loss. That is done by charging a higher interest rate. Nations may debase their currency in order to gain some perceived advantage and Congressmen like inflating because it gives them "money" to spend on pork without having to raise taxes, but justice holds the scales and all is balanced eventually.

My theory on the prices and the prime came out of watching two indicators, the prime rate and the Commodity Research Bureau's Futures Index, move up and down in tandem. I used the prime rate because it is the "business" interest rate and not exceptionally volatile. Its movements are smoothed out. I developed a chart to watch them both at the same time by simply overlaying the CRB over the prime and comparing peaks and valleys. I soon found that if I used an eight percent prime to equate to 210 CRB, and every 10 points CRB as an equivalent percent in the prime (e.g., 220 would be equal to a nine percent prime, a seven percent prime would equate to 200 CRB) , that the peaks and valleys matched up amazingly. True to the old adage, a picture is worth a thousand words and the chart showed that whenever any divergence of any length occurred, it presented an opportunity to make "money" in the market for it was only a matter of time before the two indexes came together again.

Perhaps it is time to revisit the prices and the prime theory and ask what the outlook for interest rates and commodity prices may be based on what the chart shows and other indicators.

RISPRI or FALPRI

The chart in Figure 1 shows that we are currently at equilibrium. The Fed has just recently raised interest rates a half point and the trade is sensing that another hike could be in the offing. Within the commodities themselves there are some aspects of supply/demand that may cause the price of individual commodities, or groups of commodities, you affect the overall index. For example, the supply situation in crude oil has driven up the cost of transportation for all goods in the U.S., but this rise in prices was not a result of the inflating of the money supply, it was due to the statistics for crude oil. Weather concerns and the prospect of a drought this summer in the U.S. have sent RISPRI fears through the grain markets this spring. But, other than that, the CRB has only recently come off its lowest level since 1977. The U.S. currency has been strong on balance against most other currencies and this is generally deflationary, meaning that prices tend to fall when the currency is appreciating and improving in purchasing power. The huge rise in the stock market has been inflationary—that is, an increase in asset value could result in prices of goods and services being driven higher as people borrow against the rise in their portfolio valuations—but this does not yet appear to have happened and all the technical indicators are suggesting that a top may be in place. The Fed's move to raise interest rates in this scenario, with perhaps another hike to come, will put the nail in the coffin of this bull market.

Figure 1

Money supply statistics from the Fed indicate a static situation in M-1 with only a modest increase in currency and demand deposits-up 1.5 percent year to year (see table in Figure 2). GNP figures would indicate that money supply could grow a lot more and not cause RISPRI. So raising interest rates would seem to be unnecessary and, in fact, would indicates that the possibility of FALPRI is a reality. The Fed may err on the side of keeping prices from rising when there is no such threat. Actually, in an environment when money substitutes are not being inflated, rising prices of such things as crude oil and grains tend to squeeze the consumer who has a fixed amount of disposable income, which has to be doled out among household expenses. More money spent on food and gasoline means less money for other items. As far as the stock market is concerned, the money that has gone into the recent bull market came mainly from bank CDs where the principal was secure. The fact that holding stock puts principal at risk has not sunk in yet. When the current bubble bursts there will be such a run for the door by these "weak hands" that we could see the Dow back under 5,000 in a twinkling. If we learned nothing else from the crash of 1929, we did learn that stock market crashes cause depressions, and depressions (economic slowdowns) cause FALPRI.

Figure 2

Currency Component of Money Stock Plus Demand Deposits Seasonally Adjusted (in billions of dollars)			M-1 Money Stock Not Seasonally Adjusted (in billions of dollars)
Date 4/99 5/99 6/99 7/99 8/99 9/99 10/99 11/99 12/99 1/00 2/00 3/00 4/00	CURRDD 847.226 846.072 844.286 847.540 847.788 846.478 852.409 859.972 871.536 869.720 856.570 860.050 859.325		Date 4/99 5/99 6/99 7/99 8/99 9/99 10/99 11/99 12/99 1/00 2/00 3/00 4/00	M-1NS 1113.50 1096.42 1098.35 1097.67 1093.48 1087.09 1095.12 1112.82 1148.29 1127.80 1097.20 1108.33 1124.23
Source: H.6 Release—Federal Reserve Board of Governors

Lawrence Sarsoun is the owner of Wren Services where he trades commodities for individuals in Power of Attorney accounts. Read The Sarsoun Report at www.wrenservices.com.