Follow The Bottom Violation
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Feb
2
An Inflationary Depression
I received this from a reader a few days ago:
“You say your biggest concern is that the Fed will not be able to sell Treasuries without driving yields higher if inflation comes back. But wouldn’t the Fed want to make yields higher if inflation comes back? Wouldn’t they want to discourage borrowing and investment by making yields higher?”
As you probably know by now, I don’t believe there is a distinction between price inflation and monetary inflation; I believe that all inflation is defined as an increase in the money supply — including credit. In other words, general price increases are the result of inflation — whether from printing excess money or by easing lending rates to the point that credit expands. Either way you look at it, the way the Fed typically deals with the problem of rising prices is to decrease credit by increasing target rates, and/or by selling Treasuries — thereby decreasing the number of dollars in the system. The latter has a second benefit (if you can call it that): as the Fed sells Treasuries, it increases yields, further discouraging investment.
This whole game is predicated on a thriving economy, with low unemployment and high consumer confidence. Why? Because if the economy is doing poorly, and the Fed starts increasing interest rates and selling Treasuries, it will only discourage borrowing and investment — and that’s the last thing an ailing economy needs. The term used for such such conditions — that is, a sluggish economy with rising prices — is stagflation. This is precisely the type of environment the United States experienced in the late 1970s and early 1980s, and this is why I’ve said so many times recently that Paul Volcker — then Chairman of the Federal Reserve — was luckier than he was skillful when he restricted rising prices by driving the Fed’s target rate above 20%. And, of course, stagflation was what Ben Bernanke feared more than just about anything in 2008, when inflation (his definition) went over 5%, at the same time the economy began to slow.
Stagflation is the Fed’s worst nightmare because — as I illustrated above — it is extremely difficult to combat. On one hand, the Fed needs to stimulate a weak economy, and the way it does that is by lowering rates and increasing the money supply. On the other hand, the Fed claims its primary objective is fighting rising prices, which it typically does by raising rates and decreasing the money supply. So you can see the problem stagflation poses.
In recent weeks, a lot of data has suggested that credit is easing and that banks are starting to lend again. It’s important to note that the Fed has printed more money than ever in history, and the only thing keeping that money from causing massive price increases is that its velocity is low — that is to say, the money isn’t getting into the hands of consumers and producers; it’s staying in the banks.
But if credit is loosening, that deluge of money is going to hit the economy hard at exactly the same time that credit begins to expand again. And when this happens, prices are going to go much higher. But as I said in my article yesterday, this environment presents a huge problem: demand for goods and services has collapsed, and when the tidal wave of money and credit hits the system, the resultant rising prices aren’t going to derive from the fact that assets are becoming more valuable to people, but rather, from the fact that the U.S. dollar is becoming less valuable. The economy will still be sick, and yet prices will be rising.
So what will the Fed do? It can’t lower rates; they’re already at zero. It could buy Treasuries, but that would require printing yet more money, further deteriorating the integrity of the dollar. And now we get to the most interesting — and frightening — part of the stagflation conundrum: as the economy continues to suffer and the Fed considers new, creative ways to ease, it will also simultaneously have to consider raising rates and selling Treasuries in order to restrain escalating prices. But even if the Fed decides that restricting trumps easing, it can’t sell Treasuries because doing so would drive interest rates higher, further dampening investment and borrowing — and that would only do more damage to the economy.
Oh, what to do…
Most pundits incorrectly believe government stimulus is going to re-ignite prices only after the economy has recovered, and that the Fed will therefore be able to play its game with the same old rules — combating rising prices by easing. I totally disagree, however, because of the three factors I’ve cited so many times in recent weeks: first, the U.S. is now a debtor nation, with unprecedented obligations to foreign governments. Second, its manufacturing base has all but disappeared. And finally, the consumer is broke with no savings and no credit. All of this will contribute to further deterioration of corporate earnings and dividends, and unemployment will climb higher still. The economy simply cannot recover quickly from these circumstances — if at all.
I’m highly confident that rapidly rising prices will return sooner than any economic recovery; indeed, the reason I believe the economy likely won’t recover at all is because the Fed will have fewer resources at its disposal than at any other time in history, at precisely the point it will face the worst stagflation in U.S. history.
I know many of you don’t want to hear it, I’m more convinced of the U.S. dollar’s demise than ever. A lot of people have been asking me what we can do about it — decrying my predictions as meaningless because I offer no accompanying solutions. Well disparage me no longer, because as individual investors, there’s a lot we can do — namely getting on the opposite side of the dollar and Treasuries.
But as a nation…? No, there’s nothing that can be done. More than at any other time in history, Washington needs to get out of the way, and yet Washington is interfering on an unprecedented scale. But maybe you still believe our beloved politicians can get us out of this mess.
I’ll tell you what. Why don’t you hold your breath while I count to 8.5 trillion.
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Disclosures: Paco is long TBT, UCO, and gold. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies.
You can buy his novel Discipline wherever books are sold.
1 Comment so far
Partners
Paco…, that appears to be right on with what i’ve been saying for a few years. Now all you need to do is put the pieces together and understand that this is all part of a grand agenda, yes, a conspiracy, to create the “New World Order”.
Have you watched “America: From Freedom to Fascism” yet?
video.google.com/videoplay?docid=-1656880303867390173