The Fed: Inflationistas, Par Excellence

Stock and bond markets rallied on Tuesday after the Federal Reserve announced that it will give away new money for almost free, lowering the Fed Funds target range to a historical low of 0% to 0.25%. The Fed had cut the Fed Funds rate in late October by 50 basis points. The new record low rate is a reaction to the de facto status quo in treasury securities, with maturities of up to 6 months trading at yields below the upper end of the target range.

While markets welcomed the bold move, gold, the canary in the mine of inflation, advanced as well, piercing the important resistance at $850. Investors are obviously pricing in that all Treasuries yield less than the current inflation rate of 3.7% YOY.

But the move to a zero interest rate policy will come at the cost of higher inflation in 2009 and 2010, it can be safely predicted. Chairman Ben Bernanke and his fellow Federal Open Market Committee (FOMC) members pulled out all stops in order to jumpstart the economy and assured market participants that the Fed would continue to engage in the dubious game of printing fresh money for collateral it does not want to talk about.

Once more proving their image of inflationistas par excellence, the FOMC said the Fed can be expected to hold on to its free money policy for quite some time and use all tools to promote a return to growth.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. In particular, the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

But money for nothing alone will not help, the Fed reasoned, preparing markets for more growth in the Fed's balance sheet after it exploded from $800 billion to $2.2 trillion since last summer. Expect the Fed to continue to buy more worthless MBS (mortgage backed securities) while substituting the banking sector in the commercial paper market.

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

I translate this into "we will throw (fiat) money (that costs us next to nothing) on every problem as we did in the past 2 decades." See, more worthless money is created and will be exchanged for more MBS that are valued on a theoretical basis, i.e. not the market price which may be only a tiny fraction of the initial face value.

The announcement that the Fed is looking into buying longer term US Treasuries raises immediate fears that the Fed will be monetizing the federal debt again after a portfolio shift towards MBS in the recent past. Any talk about deflation misses the point of unprecedented monetary inflation that will show up in the real economy 2009/10.

Eric de Carbonnel argues at DollarDaze that monetary inflation does not even have to pump up money supply - my favorite theory - but that it is a loss of confidence that increases the velocity of money, resulting in the danger of hyper inflation.

The record low official Fed Funds rate may be elusive though. Jake at EconomPicData sees a disconnect between municipal bonds and Treasuries, reflecting the horrendous outlook for cash strapped communities which had invested heavily in property debt. Now they are broke.

GRAPH: The yield spread between Munis and 5-year Treasuries soared to a record high of 325 basis points. Graph courtesy of EconomPicData.

DollarDaze draws a historical comparison that shows deflation can be a hazy illusion.

As an example of deflation leading to hyperinflation, consider the case of the Weimar Republic. In 1920, Germany experienced a deflationary collapse, with the average citizen finding it harder and harder to get enough money for necessities. Banks, short of money, could not honor checks, and businesses were strapped for cash to buy materials and meet payroll. Fearing a collapse that would throw millions of workers out on the street, the German government desperately printed money in an attempt to re-inflate the economy. During this period, despite the government's money printing, the mark actually gained in value against foreign currencies, so that prices of imported goods fell by some 50%.

Eventually, as a result of the money supply's rapid expansion, the nation's massive foreign debt, and the shrinking economy, German citizens lost all confidence in their currency, and the Weimar Republic experienced one of the worst cases of hyperinflation in modern economic history.

Check out the time series of the Weimar hyper inflation - with the interim "correction" before it went parabolic - here.

The new policy to lend money to banks for free shows that the Fed is obviously willing to monetize all debt problems that come along. WIth its seven new financing tools introduced since the beginning of the crisis in August 2007, the Fed is already intervening in MBS markets as it tries to keep the commercial paper market afloat.

But after all, these attempts are nothing more than new fiat money with a different ribbon. The road to hyper inflation is clearly visible as were most of today's problems more than 3 years ago.

Time will show whether the Fed has been correct in its view of current conditions. Taking it from the past 15 months, the Fed has been behind the curve despite its fast moves. It is to be doubted that the increasing readiness to prop up all markets with new money will mitigate the crisis. It will more likely delay it but the point of no return comes closer with every day. Central banks have a bad record of containing inflation once they set the process into motion willingly.

But these facilities have not brought the liquefying effect the Fed had hoped for. So far all attempts to revive credit markets have failed, observes Bloomberg, which has all the details on Tuesday's rate decision.

Comments

[Paul12345:]

Reading this makes one worry... 24 months ago hyperinflation scenarios were still only followed by some obssessive gold bugs... today, after all that happened, hyperinflation seems a lot more realstic than before.

So: what if we really move into the 'darkest of dark' realities?

If we get hyperinflation: will that be the end of the current 'world order'?
Unemployment rate worldwide 15-20% for 10-15 years?
US Dollar to 20 for 1 EUR... or complete destruction?
What about Asia (China/India)? Europe? Can they keep business going?
Will we need a total crisis with war to bring the world on its knees and to make room for a recovery... somewhere in 2035?
What to do with any money left - now? What is Warren Buffett doing?

2008 Dec 17 11:12 AM

[Chris B:]

"Central banks have a bad record of containing inflation once they set the process into motion willingly."

This would be a much more interesting article thesis than the backwards-looking Monday morning quarterback analysis presented here. Tell me WHY I should believe that the contractionary policies of the future such as higher interest rates, open market bond sales, or even raised reserve ratios will fail to reabsorb the liquidity recently dumped on the market. Why is this time different from the last time rates went to historic lows and government debt increased dramatically (i.e. like 5 years ago)? Everybody is so fixated with how we got where we are that they are not looking forward to the next chapter. Weimer Republic fantasies provide no forecasting information for 21st century US inflation/deflation rates. They also failed to predict the current deflation, a detail conveniently omitted in this article.

2008 Dec 17 11:21 AM

[CautiousInv...:]

With respect to monetary easing, effectiveness of this policy will depend upon where we are in the intertwined develpments of economic contraction and financial delevering. If we are are not late, then monetary easing should prevent economic collapse and and deflation. The Japanese were three years late and lost a decade. The two apparent unintended consequences: currency devaluation and inflation are more problematic. Thus far, markets are punishing the dollar and are likely to do so until there is some sense or understanding of how far this process is likely to continue. But to instill confidence in the equity markets, Bernanke has said he will stay the course and do everything necessary to forestall economic contraction and deflation. In my mind, this leaves room for the dollar to fall further while sewing seeds for higher inflation through higher import prices. The more important aspect of inflationary threats, though, hinges upon the ability of the Fed to "time" the point at which it should take the hot money out of the system and reduce the size of its balance sheet. Given its recent track record in timing the implementation of interest rate policy, I am not terribly optimistic about their ability to time the point at which they should contract the supply of money.

2008 Dec 17 11:23 AM

[sickofthehype:]

Buffett has big plans for 2035 I hear.

PS-
I see the worst case scenario articles have gotten the best of you


On Dec 17 11:12 AM Paul12345 wrote:

> Reading this makes one worry... 24 months ago hyperinflation scenarios
> were still only followed by some obssessive gold bugs... today, after
> all that happened, hyperinflation seems a lot more realstic than
> before.
>
> So: what if we really move into the 'darkest of dark' realities?
>
>
> If we get hyperinflation: will that be the end of the current 'world
> order'?
> Unemployment rate worldwide 15-20% for 10-15 years?
> US Dollar to 20 for 1 EUR... or complete destruction?
> What about Asia (China/India)? Europe? Can they keep business going?
>
> Will we need a total crisis with war to bring the world on its knees
> and to make room for a recovery... somewhere in 2035?
> What to do with any money left - now? What is Warren Buffett doing?
>
>
>
>
>
>
>

2008 Dec 17 11:26 AM

[Jason Rines...:]

Here's my take: This is the biggest asset/debt bubble in history Chris. No one knows how much money will even be required to avoid further recessionary to depressionary conditions. The positive feedback effect has really recently take hold beginning of Q4. The Central Banking system knows what is coming, such events we are seeing are hundreds of years old, England, France and Germany are excellent models to look at for past historical reference of cause and effects. I forecasted these events as a CEO with a couple of number crunchers on my staff in July of 2007 stating a chance of recession was 100% in 2008 and chance of depression was 50% based on Washington response. I forecasted that 10% excess would come off of our GDP by March of 2008 seeing only monetary policy put into play and NOT serious fiscal stimulus. At that point chance of depression coming was 100%. You can view my endless comments of me stating this eight ways to Sunday by doing a search of 'ithinkbig' here on SA.

The Central Banks response is highly predictable as the writer states. Was it a surprise the Central Banks created a reckless and urgent need for Treasury to provide $300 B to protect there own intertwined investments with the Investment Banks in October? NO! Will some of this money reach the real economy someday? YES! We have lost 10% of our GDP this year, make no mistake about it. GS states -5% GDP this quarter, 3% next quarter and 1% afterwards. The numbers are a tad more and this has happened already. Like the NBER report, we won't see the real numbers until a year from now. This depression will be a W shape. We are finishing up the first leg down (first 10%). The next 10% deflation is what the Fed is desperately fighting. I forecast deflation/inflation but do not believe the U.S. will be Wiermarch, 1923. I believe will see inflation, but more like 2010/2011. The Fed is losing the deflation battle and in real terms, it does take a year for money to reach the real economy. The real economy being made up of 51% GDP small business that is being slaughtered and the 28% GDP of bigger business that also is seeing some cash flow problems. The last 22% is of our GDP Government, haven't seen much deflation there, have we?


On Dec 17 11:21 AM Chris B wrote:

> "Central banks have a bad record of containing inflation once they
> set the process into motion willingly."
>
> This would be a much more interesting article thesis than the backwards-looking
> Monday morning quarterback analysis presented here. Tell me WHY I
> should believe that the contractionary policies of the future such
> as higher interest rates, open market bond sales, or even raised
> reserve ratios will fail to reabsorb the liquidity recently dumped
> on the market. Why is this time different from the last time rates
> went to historic lows and government debt increased dramatically
> (i.e. like 5 years ago)? Everybody is so fixated with how we got
> where we are that they are not looking forward to the next chapter.
> Weimer Republic fantasies provide no forecasting information for
> 21st century US inflation/deflation rates. They also failed to predict
> the current deflation, a detail conveniently omitted in this article.

2008 Dec 17 12:05 PM

[Dr.Jackpot:]

WON'T DISCUSS IT

My father wouldn't discuss it because growing up he didn't want me to compare him to other men based on money and he thought I might be ashamed of him.

My mother wouldn't discuss it because she was obedient to my father and didn't want to make any waves.

My older sister wouldn't discuss it because she failed all her math courses and couldn't tell you what 3% of 100 was. She planned to get by on her big t-ts.

My brother-in-law wouldn't discuss it because he thought I was stupid but he was afraid I would find out he was even more stupid.

My broker wouldn't discuss it and I didn't care because I assumed everything he said was geared towards churning my account.

My doctor wouldn't discuss it because he didn't want a patient to realize the massive overcharges he was accumulating.

My neighbor wouldn't discuss it because his greatest fear was that I had more of it than him. His second greatest fear was that I had less of it than him.

My wife wouldn't discuss it because 10 words into the conversation would send her ballistic every time. Her take was if I made a profit it was half hers but if I took a loss it was all mine. There was nothing else to know.

My daughter wouldn't discuss it because she didn't want to appear interested in her inheritance and risk losing it.

My son-in-law wouldn't discuss it because he was afraid that if he wanted to borrow from me, I would know that he didn't need it.

So I have tried to talk to God now that I'm old and afraid. But so far he won't discuss it.

2008 Dec 17 12:23 PM

[Obviously t...:]

Anyone have data on the immigration rate in Germany during the period of hyperinflation time? Please post it here.

2008 Dec 17 12:29 PM

[Teutonic Kn...:]

Prudent Investor, great article, well-researched, substantive and insightful.

Paul12345, your numbers are scary but I don't think they are improbable, meaning quite likely to put it mildly. My gosh!

I am not an economist. I owned quite a bit of TIPS. In last September I saw the re-inflation of the bubbles coming and I hanged onto and bought more TIPS. They sank like a stone from September to last November, only starting to come up a bit lately.

So Why??? The present trend is clearly hellish inflationary even the blind could see it. Now I know why at least partially. Things got so bad with the hedge fund folks, the banks, and the brokerage houses that they HAD to sell TIPS to raise cash to meet margin and redemption demands. If this were true then the present crisis is unprecented.

Don't hold your breadth yet.

2008 Dec 17 01:24 PM

[who:]

Markets are markets. I never understood why markets go up when interest rates are reduced in a situation where reduction is needed to promote "growth". Growth can only come when people feel secure and can see a bright future. As it is now, the future is very bleak. The strongest in society has fallen where does this leave the rest of us?

2008 Dec 17 01:42 PM

[Socialism c...:]

See below.

On Dec 17 11:12 AM User 321351 wrote:

>
> So: what if we really move into the 'darkest of dark' realities?
>
>
> If we get hyperinflation: will that be the end of the current 'world
> order'?

Um...worry? darkest of dark? I'd WELCOME the end of the "current world order"!!! This "central bank" hogwash is one of the big causes of this mess, along with excessive and unjust taxation, unconstitutional *means* of taxation, and overgrown, controlling, police-state government!!!

> Will we need a total crisis with war to bring the world on its knees
> and to make room for a recovery... somewhere in 2035?
> What to do with any money left - now? What is Warren Buffett doing?

You shouldn't do what WB does...he is in a different "situation" than you are!!

2008 Dec 17 02:45 PM