Money Supply Zooms, Inflation Will Follow

Since late 2007 the money supply (M1) has zoomed up from $1.4 trillion in November 2007 to $2.3 trillion in July 2012, according to the Federal Reserve Bank.    That's an increase of 64%.  The economists who, for the past four years, have been talking about the risk of deflation must have been out of their minds.  Moreover, the monetary base, which banks use to inflate the money supply up to ten times the reserve amount (known as the reserve ratio), has increased from $825 billion in January 2008  to $2.7 trillion on August 8, 2012. That's an increase of 318%.  According to the Bureau of Labor Statistics, prices have increased a mere 10.5% from December 2007 (CPI = 207.3) to July 2012 (CPI = 229.1).   The dollar's fall against relatively stable currencies, the Swiss frank and the Chinese yuan, has also been modest.  According to the Fed, the dollar has fallen from 1.12 Swiss franks on January 2, 2008 to 0.97 Swiss franks on July 8, 2012.  That's a fall of 13.4% percent.  The dollar fell a similar 12.8% against the Chinese yuan during that period.

I obtained the graph below from the Council on Foreign Relations. 

 

Part of the explanation of the low inflation rate and modest decline in the dollar is the increasing gap between foreign and US holdings of  each others' financial assets.  The imbalance is pronounced with respect to treasury bonds (graph also courtesy of the Council on Foreign Relations):




The absolute amount of borrowing has increased in step with the foreign share.  If treasuries yield 1.8% and the dollar is decreasing in value by 2.75% (12.8% / 4 years, 8 months), then China has been consistently losing money on its Treasury bonds.  Of course, by purchasing the bonds China stimulates demand for the dollar, which strengthens US demand for its manufactures.  Assuming China profits from the sale of its manufactures, it may be breaking even or better because of the treasury bond losses.  

Is this system stable?  It would seem that if the US monetary base has increased 318%, then the money supply will eventually follow--perhaps to the tune of 10 x $1.9 trillion (the increase in the monetary base) = $19 trillion, or 700% times the current money supply.   If so,  the losses that foreigners sustain from holding treasury bonds will increase, and many will sell in order to ease their pain.  The result will not be a trip to the field of dreams, but to an American citizenry facing a falling standard of living, perhaps markedly so, as inflation takes off.