When will inflation cool off?

Watch: Money supply
Current read: No cooldown yet

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By Janice Revell, Money Magazine senior writer

As you know all too well from the skyrocketing cost of the milk you put in your cereal and the gas you pump into your car, inflation is back. Consumer prices are rising at 4% a year - well above the 2.6% average annual increase of the past decade.

Predicting inflation is one of the most hotly debated areas in economics. Still, there's one signpost worth watching.

What to watch: Follow the money supply. When the Federal Reserve cuts rates, it often does so by buying Treasury bonds from banks, giving them more money to lend and thereby pumping more money into the economy. When the growing supply of greenbacks outstrips demand, each dollar is worth less and buys less.

Presto: inflation. Every major increase in inflation over the past century has been preceded by a spike in the money supply, and a dip in the growth of the money supply has usually led to a drop in the inflation rate.

In the early 1980s, when inflation topped 10%, then-Fed chairman Paul Volcker embarked on an aggressive campaign to slow money supply growth and tame inflation. He succeeded - by 1983, inflation was 3.2% - but at a price. Clamping down on the money supply helped trigger a severe recession - one reason today's Fed is under pressure to keep up money supply growth.

What it's saying now: Going by the money supply, odds are good that inflation will continue rising in coming months. Since last September, the Fed has been on a rate-cutting tear, slashing the federal funds rate by three percentage points in an effort to stave off recession.

As a result, the money supply measure known as M2 has grown by a compound annualized 14% rate over the past two months. To put that in perspective, M2 grew at an average annual rate of 6.1% from 2000 to 2008.

To keep track: You can look up M2 at the Web site of the Federal Reserve Bank of St. Louis.

The wild card: It's not just the Fed that has control over our money. The owners of U.S. dollars can increasingly be found outside the U.S. China holds an estimated $1 trillion, much of it in the form of Treasury bonds. A decision by China to liquidate even a modest portion would drive up the money supply.

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