Inflation, Deflation, or Hyper-inflation?

Well it seems that the $787 billion stimulus package and the countless trillions doled out by the Fed designed to get our economy back on track is starting to stall out. Conventional economic theory says that when private sector demand falls off a cliff, it’s the governments job to step in and boost demand. This has worked in the past i.e. (recession of 2001), this depression however is different. The recession of 2001 was an equity recession so pumping money into the economy worked to boost stock prices, one unintended  consequence was that it also spurred a lending boom that flowed into housing. This is the central difference between this recession and the last one, 2001 was an equity recession 2008 to present is a debt recession. This is also the problem with conventional economic theory. All the textbooks tell Bernanke to print, print, print to rescue us from the perils of deflation which would work in an equity recession but not in a debt recession and especially not one of this size. By the banking industry’s own estimates there are $5 trillion worth of bad loans sitting on their balance sheets dragging them under water. This is why banks are not lending. Unfortunately the textbook response to increase the money supply to jump start lending is backfiring

The next problem with conventional econ0mic theory is that it states that inflation requires two things 1. an increase in the money supply (check) and 2. monetary velocity (nope, look at the chart, banks aren’t lending) this is where the deflationists get their proof. This however is a misguided approach in that they don’t factor in peoples perception of the future value of money. If you truly want to measure inflation, look at a chart of gold, as gold cannot be produced from nothing so it therefore maintains it’s purchasing power.

If you believe gov. statistics then inflation is an average of about 3% a year, but here’s the catch they don’t include “volatile” food and energy prices when calculating inflation. Wait a sec. thats means that if food and energy rise 30% and everything else rises 2% then inflation is only 2%. Does this make any sense? Didn’t think so. But wait how could we have inflation without banks lending? There’s that market psychology again. This is why I believe we will spiral into hyperinflation (or at the very least double-digit inflation like the 1970’s). The textbooks say that Bernanke has to hold down interest rates (print money) till unemployment comes down to an acceptable level (about 5%). The problem is that in a mean time prices will have skyrocketed by then because unemployment is at about 18% and employers aren’t hiring. If the Fed does print us into oblivion we will all end up like Zimbabwe.

Yes, you read that right, $100 BILLION for three eggs. The only thing that will stop us from this fate is the Fed stops printing yesterday. It will not be pretty, it will not be nice, but I prefer 25% unemployment to $100 billion for three eggs, don’t you?

New Home Sales Down 33%

We are witnessing the first slip in a long and steady slid for housing prices, with the government tax credit expired, consumers now have no incentive to take on 2, 3, or 4 hundred thousand dollars worth of debt. The combination of high unemployment, non-existent job security and very tight lending conditions have all but extinguished consumer demand. All this will lead to depressed home sales and home prices for years to come. This is the beginning of a double-dip recession, not in nominal terms but in real terms.

Congress finally gets what it asked for.

Over the weekend China has allowed it’s currency to float, albeit with a watchful eye, against the dollar. For years politicians have howled about how an artificially cheap yuan (relative to the USD) has hurt U.S. manufacturing by making Chinese labor ever cheaper then American labor. Since 1994 the yuan has been pegged to the dollar and as a side effect has let the U.S. run up endless trade deficits as well as export our inflation caused by the Fed to helpless Chinese workers. The upside to the peg was that China places all the dollars she accumulated to U.S. Treasury bonds, so in effect every time someone spent their unemployment, welfare, or other gov checks on anything “Made in China” they were in effect funding their own parasitic existence, less of course the $2 per day the average Chinese worker makes and shipping costs. The People’s Bank of China maintained the peg by selling yuan vs. treasury bonds, unfortunately for spend happy politicians in Washington the end of the peg also means that the PBOC no longer needs to buy treasuries. This is not only the death of endless budget deficits but also of insanely low interest rates. As China stops buying treasuries, the U.S. will have to turn to Helicopter Ben and his printing press (thanks a lot Gutenburg). The final showdown will be between Ben Bernanke and the invisible hand. As Bernanke prints and prints, investors will demand ever higher interest rates to compensate for the decline in purchasing power. A good pre-game show would be if Greece had it’s own currency, it would surly be worthless by now.

The EU and the nuclear option.

Well anyone who watches the currency, bond, or stock markets know what the EU did on sunday night. In a desperate attempt to stem the slide on the euro into the abyss the EMU along with the ECB, European governments and the Fed launched what could quite possibly be the single most inflationary act in the EU’s 11 year history. This marks a historic event as Sunday is the day the Euro died. Think about it, the rescue package is a mix of loan guarantees from EU gov, currency swaps with the U.S. and outright quantitative easing from the ECB. so what does that mean? German taxpayers are going to absorb losses from banks that threw money into a black hole (loaned money to Greece), the Fed is going to swap (print) dollars for euros and the ECB is going to buy gov. debt through the secondary market with printed money. Now correct me if I’m wrong but, you don’t pay off a credit card by spending more on it right? Now needless to say many of you are yelling that if it worked for the Dollar it’ll work for the Euro. This argument misses one important point however. There is one huge differnace between the dollar and the euro, the dollar has enjoyed global demand as the worlds reserve currency while the 11 year old euro is a second rate alternative. All these factors combined will lead the euro to its intrinsic value of nothing as the ECB will be forced to print ever more euros to pay off the euros owed.

It’s been awhile

I recently listened to Ben Bernanke testify before a U.S. House committee on monetary policy and the dollar. During his speech Bernanke tried to make the case that the the general level of domestic prices does not have a close (or even general) correlation with the value of the dollar. To his credit he did point out that the Fed has only the goal of “price” stability (considering that a movie ticket that used to cost $.10 and now costs $9.50, not exactly what I call price stability but hey he’s the Ph.D) to consider when setting monetary policy. There is a fundamental flaw with his rational however, that is, he separates the value of the dollar from the market pricing structure. This in my opinion is a fatal flaw, take crude oil for example, traders, countries, even ordinary people, see the intrinsic value in a barrel of oil. No matter where you are in the world people need oil. The U.S. Dollar however can only be used to pay for goods and services in the U.S.A. The U.S. dollar isn’t worth the paper it’s printed on. Just look at the inflation of the 1970’s, which was incorrectly attributed to the price of oil when it was in fact the affect of Nixon closing the gold window. Nixon closing the gold window had the effect of devaluing the dollar by 20-30% . This was the real culprit behind the double digit inflation of the 70’s. 

As you can see the price of oil spikes 30% in the mid 70’s and even higher in the early 80’s. As you can see gold is taking a similar path with all of the QE that the Fed has engaged in. 

Price stability is all about the markets perception of value of the currency that the good are being priced in. As the value of the dollar slowly erodes the prices of commodities will rise to compensate. In this regard the price stability IS the markets perception of the value of the dollar. 

Is Quantitative Easing going to destroy the dollar?

We have all heard the phrase “Quantitative Easing” (QE), but what exactly does it mean? Under normal circumstances the Fed regularly engages in printing money for various reasons (shore up banks, so banks can engage in lending, etc) however we are currently in extraordinary economic times. On Dec 16, 2008 the Fed lowered the fed funds rate (FFR) ( the rate that the Fed lends money to the banks and banks lend to each other) to 0% – .25%.  Now to fully understand the fed funds rate you have to think about it as a faucet that controls water. Now when the FFR is at say 6% that’s equivalent to drip, drip, drip, in terms of new money being created and flowing into the economy causing a light inflation of about 2-3%/year. Also inflation depends on two things. First, there must be new money flowing into an economy. Second, there must be money velocity which means people mush be spending the newly created wealth in the economy. The FFR at 0%- .25% is the equivalent to ripping the faucet out of the wall and letting the water (money) gush out into the economy. The Fed has a couple of tools at it’s disposal to combat a recession/ depression. They can lower the FFR to cheapen the cost of credit (money) which they have done. Lowering the FFR in effect makes it dirt cheap for banks to lend money to worthy borrowers to get the economy growing again. Unfortunately there is a limit to the effectiveness of the FFR as banks are still not lending money and the Fed cannot have a negative FFR. This is where QE comes in. Instead of just lowering the “cost” of credit, the Fed actually buys bad assets (ABS, MBS, CDO, CLO, AMBS, Bonds, etc) from the banks, the idea being to replace all the toxic assets on the banks balance sheet with hot-off-the-press money so the banks can engage in lending again. Unfortunately this chart proves that’s not happening.    
                                                  

This is a chart of total bank credit being given to credit worthy borrowers and total excess reserves held by banks (the amount above and beyond what they legally have to keep on reserve/the amount they can lend out). This chart proves that QE is doing nothing except debasing our currency with each and every grind of the printing press.
                                 
The U.S. has in my opinion entered an economic phenomenon called a liquidity trap. This spells disaster for the dollar. Eventually when the day of reckoning comes and the Fed is forced to raise interest rates say goodbye to the welfare-warfare state as the federal government will default on its debt. I feel sorry for our service man/women.

What’s driving commodities?

Well the EIA Petroleum Report came out and crude inventories rose 1.3 million barrels and yet oil is sitting at $80.53. Now under normal trading circumstances and increase in supply with flat demand would lead to a DECREASE in prices. But wait, why is the price of oil going higher if there is an INCREASE on supplies, did Adam Smith have it wrong all these years, or is the value of the dollar declining in value in relation to “hard assets”? I’m going to go with the dollar declining in value. The U.S. in the depths of a VERY deep recession and the combination of unemployment being at 9.8%, capacity utilization at all time lows and record federal budget deficits all create the perfect storm to bring the dollar to it’s knees. Unfortunately for anyone who drives a car, eats food or doesn’t live like a hermit all this devaluation will lead to massive price inflation in oil, gold, silver, copper, and it will also kill anyone living on a fixed income (i.e. social security). If you think last summer was bad for oil prices, just wait and see. The next 12-18 months will make the late 70’s look like paradise.

Stagflation for the Foreseeable future.

I love all the back-and-fourth between the authors here on Seeking Alpha. HYPERINFLATION!!!!!!!!!!!!!!………DEFLATION!!!!!!!!!!!!!!!……..well guys, your both right and your both wrong. The inflationist’s make the argument that with all this money the Fed is “printing” that we will fall into a hyperinflationary spiral. This may be true in the long run with all the recent calls by China and Russia for a new global monetary standard (which I do feel the dollar’s days are numbered) and all the major currencies hitting new high’s against the dollar every day however the dollar will stay the global reserve currency as long as commodities are priced in dollars. The inflationists point to money printing as the death nell for the dollar as evidenced by the explosion in the monetary base

Another argument I don’t often hear made is one that when it comes time for Bernanke to raise rates he won’t have the political will to do so because it will make the interest on the federal debt skyrocket. Interest on the federal debt is just under $200 billion per year and thats with 0%-.25% rates. research.stlouisfed.org/fred2/graph/fredgraph.png
It is also true that we have seen/will see price inflation in commodities (i.e. oil just under $80/barrel, gold at $1060/oz. this however is not due to demand as the global economy has not recovered yet, this is due to a “store of wealth” mentality.
Now the deflationists argue that there is much too much slack in the economy for us to see inflation anytime soon they point to capacity utilization (looking at the Cap. Utlz. graph according to the deflationists we should have had deflation since the late 70’s) and available credit to consumers.

Both these graphs alone prove that consumer demand will not return to pre-bubble levels for some time especially with unemployment at 9.8% (conservative estimate). These two factors (money printing and a extremely weak economy) set the stage for stagflation. We will end up with two scenarios 1. Bernanke & co. will keep interest rates at all time lows “for an extended period” which will evitabley lead to double-digit inflation or 2. Bernanke & Co. will raise rate when necessary but in doing so will not only choke off the economy but raise the interest on the federal debt to unpayable levels. If Bernanke’s actions are any indication of the future I fully belive we will see the first scenario play out just like the late 1970’s ( X and Y Gen’s, ask your parents). I believe Bernanke will be this generations George William Miller. Hopefully when all this comes to fruition the president will appoint Paul Volcker as chairman again (if that does happen though, pay off your credit cards now).