The Inflation Time Bomb 22 comments
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No one has forgotten Ben Bernanke's reference to Milton Friedman's deflation fighting helicopter scheme in a 2002 speech or the footnote of that speech that noted "inflation erodes the real value of the government's debt and, therefore, that it is in the interest of the government to create some inflation."
Surely if Bernanke was going to enlist the aid of helicopters the process should be well underway. Yet the total CPI number was a negative 1.9% in November, the fourth straight month of deflation. If you take out food and energy, the number is positive, but declining for the last four months; now effectively 0%, deflation should appear in this number next month. However, the question remains, where are Bernanke's helicopters?
It appears Bernanke decided a subway of hidden tunnels was the more efficient way to distribute money. "Bailout", Merriam-Webster's 2008 word of the year, is the next station on this rat maze to financial recovery. To this point, over $7 trillion has been issued to bail out companies ranging from Bear Sterns, AIG, Citigroup (C), JPMorgan (JPM) to the Detroit automakers. A list to track the bailouts (300 plus and counting) has been created by the New York Times and is worth checking out. The sight of it is simply astonishing.
The question remains, however, why do we see deflation and not inflation despite the tremendous amount of money being pumped into the financial system? The simple answer is the banks “know" (I use that word lightly) what assets are still on their balance sheets and have a desire to survive. They are no longer worried about this quarter's profit, but their solvency. As a result, the only safe option is to hoard money and ride out the rough seas.
The M2 money supply could not be more illustrative of the government's failure to get money into the economy. Historically, the St. Louis Federal Reserve has maintained a steady multiple of a $58 expansion in M2 money supply for every $1 added to their reserves. As of November 1, this multiple had decreased from 58 to 11. The dark subway tunnels filled full of bailouts are leading right back to the Federal Reserve not to the economy. Bailed out banks, fearful of insolvency and teetering on the edge of collapse, have no appetite for risk and are putting that money right back into the Federal Reserve and the government rewards them with interest. As a result, the Federal Reserve's asset base is growing rapidly compared to the M2 money supply effectively creating an inflation time bomb.
One major discussion still remains in uncovering the inflation mystery: who is funding the bailouts? We can thank China, Saudi Arabia, and other foreign nations for giving us the monetary noose to hang ourselves. The United States deficit has been funded by almost entirely foreigners for the last decade or so, but can they continue? This recession is not an isolated event as we now know and has spread around the globe causing countless central banks to act.
In fact, they are worse off than the United States with declines in the MSCI Index of 44% in 2008. China recently announced a $586 billion stimulus plan and others are following suit. Do we honestly believe, China and Saudi Arabia will be able to support our outrageous deficit of well over $2 trillion for 2009 into the future? (Think about that number: the US treasury has to borrow $5 billion every single day in 2009 to fund our government). Our rich foreign uncles are having to turn an eye towards their own economies, leaving us with a gigantic hole in our budget.
"What comes around goes around" is perhaps the proper slogan for our economic relationships with foreign countries around the world. When the American consumer borrowed against their homes and ran up large amounts of debt to buy toys, those toys came from our friends on the other side of the world. When Americans puts gas into their tanks at $4 a gallon this summer, that gas came from the other side of the world. In exchange, we sent them our money and they "wisely" invested it back into our Treasury. What has happened now? Our consumers went broke and now that distasteful trade deficit is starting to unwind with one nasty side effect. Our allowance from foreign countries is being severely reduced. We aren't sending our money to them and as a result they are not sending their money to us. (That $5 billion a day is looking a bit harder to find now).
That leaves the United States with two choices. Try and continue to issue large amounts of debt to foreign countries (that already have more than they want), which means higher interest rates are in our future, or simply fuel up the actual helicopters and start printing money. (Both are likely to happen). The United States government obviously will not face a liquidity crisis as long as the printing press works and Bernanke has already said he knows how to use it.
Hopefully by now (if you are still reading) I have shown you how this inflation bomb has been constructed. All that is missing is the fuse. The economy is in deflation currently and in my view will remain in deflation throughout most of 2009 as consumers and businesses deleverage and increase their savings. By definition, bubbles bursting are deflationary events and in 2007-2008 we had two large bubbles pop in the form of housing and credit. As these events unfold, so will deflation. Every story has an ending and this one has a real plot twist in its final stages.
Once the economy starts to recover, in late 2009 or early 2010, the deflation will have run its course. The ticking time bomb, however, is inflation and all it needs to explode is a little sustained optimism. As consumers begin to feel safe and look to spend again, so will banks. After all, a bank's primary business is loaning money and lucky for them they have saved every dime they could of their allowance from the government and are ready to go on a spending spree. All that money that the government has poured into the banking system and will continue to pour through 2009 will come rushing out. The multiplier effect the government has been looking for will finally occur, but it will occur way too fast and on way too much money. The result will be intense inflation starting midway into 2010.
Combine this with our own government's excessive deficit spending and the inflation tsunami has arrived. Interest rates will rise from their rock bottom rates at the cost of the debt markets as this mass storage of money is released into the economy. You remember that ratio of M2 money supply to reserves that dramatically decreased to 11? With the current money already in the system, returning to a 58 time multiplier (as history suggests) will result in a 400% increase in the M2 money supply. Now clearly the government will act to reduce the money supply once the recovery is under way, but they can't act that quickly and they won't risk pulling the rug out from underneath the banks and sending us back into economic ruin. This is a massive time bomb and the spark is the recovery itself.
I will be looking to short Treasuries in the coming months at rock bottom yields as it is only a matter of time before inflation concerns arise and the yields with them.
Disclosure: no positions
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Really? All the authors of these same 400 articles quite conveniently leave oute the second half of the equation. Who will be on the receiving end of all that money rushing out? Even after the severe hoarding thaws, the criteria to recieve credit will be much stricter. And who will want this credit?
Don't see it, sorry.
Why would you assume that? The bankers personally got rich during the bubble (big bonuses...). And in contrast to a capitalist society where they would have gone under during the collapse of the bubble, in the US the they learned the federal government would bail them out: "Privatize the gains, socialize the losses"
The author didn't talk too explicitly about the dollar being a reserve currency. And we (the U.S.) got lucky again and the dollar became a shelter in the storm just when we needed it. (Everyone ran to the dollars and t-bills when all other asset classes went to hell.) If other countries start to diversify to other currencies for the reserve currency, it's really going to hit the fan and I think we will see the inflation the author talks about.
Think about it....if I am a small business selling widgets. I usually buy my raw materials on credit (a business model under great distress because of the siezure of credit markets). I am on the brink of collapse. I am desperate for funding. I will be waiting in line to get credit lines back as well as loans for new capital investments.
Sure, you can argue that the money is going to credit worth projects because of tighter lending requirements. However, that position has two flaws. One, it assumes that these new banking giants will correct there risk management shortcomings despite the overwhelming political pressures to deploy their newly acquired capital. The second shortcoming is that with this tremendously larger capital base, loans might be tighter than the were previously but they will hardly be tight. Even if theoretically every loan they make is a good loan i.e. limited risk of default, you have essentially dumped a couple trillion new dollars into the economy. This money has a tremendous mutliplier effect that only compounds the inflation problem as jobs are created. The article correctly points out the Fed's own worst enemy is the Fed. If you cannot visualize this scenario than you are failing to think strategically about the very delimma that the Fed is thinking about themselves.
This problem is only compounded when you figure out that every equity infusion into the banks, as far as I know, does not have any kind of structural expiration. Which is to say, the only way to get this lending capacity (e.g. massive equity base that can be lent off of at some ratio)out of the system once the recovery begins is for the banks to buy back the equity stakes from the government. Now, why would a bank ever reduce their own equity stake...when their equity stake is the equivalent of their right lung when it comes to earning money?
To argue that no one will want this credit is essentially an ostrich in the sand to what has happend in 2008. If no one needed the credit, what is all the talk of crisis for?
Think about all of the new debt that the government is issuing to pay for these bailouts. This may very well be backing the U.S. into a very uncomfortable corner in which we are faced with two choices: Default or inflation.
I feel this contribution from Mr.Czirr is one which asks pertinent questions and should not be dismissed .
My contribution is to ask about future inflation scenarios.
If the bailouts escalate, as it seems they are proposed, will this not debase the currency?
Debasement of currency has a historic pedigree with a known outcome...
A bad dose of inflation at levels akin to dysentery.
With the productive base of all economies heading to Pallookaville fast, is debasement going to be the main cause of inflation. I can't see it coming from high demand leading to higher prices.
In other words if you are wrong and inflation does not kick in you lose little but if you don't invest to protect yourself or benefit from inflation and it hits us hard than you win big time.
Disclosure: Long DGP, TBT
What folks seem to always miss in this debate is that large movements in the economy (as opposed to the stock market) are almost always VERY gradual. There will never come a day when the banks as a group open up much more willing to lend than they were when they closed the day before (though the reverse could happen). These things take time.
We also need to understand the nature of the expansion of the Fed's balance sheet, the current accounting of which can be found here: www.federalreserve.gov.../. There are several major growth areas in the last year that deserve attention. In no particular order:
Depository institution deposits: $833M. This is the item reference by the author where the banks could remove this money and start lending it at any time.
Term Auction Facility ($344M, or 41% of the increase in deposits), and the Commercial Paper Funding Facility ($334M, or 40%). Here the Fed serves traditionally bank lending roles. In a very real sense, the money the banks have deposited at the Fed is being used by the Fed to fill these roles. As the banks get healthy and return to traditional lending, the Fed needs only to reduce its participation in these markets to prevent money supply growth.
Other assets: $531M, or 64% of the increase in deposits. This is primarily foreign currencies held by the Fed from unlimited dollars swaps with foreign governments to help deal with the flight to the dollar. The Fed could trade these currencies for dollars and remove them from the money supply.
US Treasury Securities: -$252M or 30% of the deposit increase. The Fed's been a seller of Treasuries over the last year, but it still holds nearly $476M (57% of new deposits) of Treasuries, which can be sold as the economy grows to slow money supply growth.
The point here is that the increase in deposits referred to by the author, while enormous, are clearly not beyond managing, and is to a great degree funding the traditional bank lending through a different mechanism. Further, since it holds the deposits, the Fed will know EXACTLY when this money is entering the economy. And the Fed has tools available to it to mitigate this money supply growth if/when it occurs.
Whether they do it well is another matter. But the more I look at the question, the more I think the risk of inflation is overblown. It's not a foregone conclusion; much depends on the skills of the Fed in managing the back end of this recession.
"...returning to a 58 time multiplier (as history suggests) will result in a 400% increase in the M2 money supply. Now clearly the government will act to reduce the money supply once the recovery is under way, but they can't act that quickly and they won't risk pulling the rug out from underneath the banks and sending us back into economic ruin."
This is the downside of "unconventional" stimulus. In 2010 when inflation heats up, government will just be getting started on the stimulus projects promised by our president elect. Will they be cancelled? Will the fed funds rate hit 10% on Paul Volker's advice?
I suspect that the government will tolerate 8-10% inflation/stagflation for a year or so, just to ensure the deflation monster is dead. Then it will be killed with the same interest rate hikes and radical open market activities that killed it last time. Treasuries will be wiped out eventually, but as with shorting ridiculous tech stocks in the 1990's, you better be patient and willing to lose a lot of money until then.
inflation in certain commodities...food...m... oil in a few years...
stimulus will pump the juice for 6-9 months..no more...Then the
government is done....and we wait for the next generation in
2020-2025 to create their boom...
dollar and tbills could stay strong...would not short anytime soon...
Euro is heading for the graveyard in 5-10 years...
The banks have an incentive, because the government money is relatively expensive. Also, TARP money is not "high powered money" and so it doesn't multiply to increase the money supply.
On Jan 15 12:03 PM DMoser wrote:
Doesn't multiply YET - I think that's the real point here, which has nothing to do with the Fed. The hundreds of billions being poured into bank capitalization will, eventually, start to be used for lending, and that's when money supply growth becomes an issue. However, the dividends and preferred status of the TARP injections provide good incentives for the companies to retire the government ownership.
And again, nothing will happen dramatically in this.
Whether the banks will lend to sub-prime borrowers is a different story. But if the government continues to buy up their 'toxic' assets, why wouldn't they? I'm confident that congress will pass yet another law that will require banks to lend to those who don't have the means to pay it back.
On Jan 15 11:17 AM patio wrote:
> " After all, a bank's primary business is loaning money and lucky
> for them they have saved every dime they could of their allowance
> from the government and are ready to go on a spending spree. All
> that money that the government has poured into the banking system
> and will continue to pour through 2009 will come rushing out." <br/>Really?
> All the authors of these same 400 articles quite conveniently leave
> oute the second half of the equation. Who will be on the receiving
> end of all that money rushing out? Even after the severe hoarding
> thaws, the criteria to recieve credit will be much stricter. And
> who will want this credit?
> Don't see it, sorry.
"Old money" which buys these TARP bonds, already had a chance to multiply. If this money was withdrawn from banks to buy these bonds which fund the money loaned to the banks, you can more clearly see that the money supply is basically unchanged by TARP.
Now, if the Fed starts to buy securities with new, "high powered money", that is what could, in the future, lead to massive money supply growth and inflation.
"And again, nothing will happen dramatically in this"
Everything will be better on Tuesday. "The One" will save us. LOL!
On Jan 16 08:04 AM BS Detector wrote:
Well, when the Fed's balance sheet grows by 80% in one year, that's new money, is it not? If not, where is it coming from?
You bet! Absolutely!
The TARP money, on the other hand, is borrowed first by the Treasury, not created by the Fed.
On Jan 17 05:26 PM BS Detector wrote:
I may not agree with the Totality or all of the conclusions, but I certainly welcome the discourse.
I doubt whether SeekingAlpha was designed to gather society's Alpha personalities but they are certainly here.
So, if you find yourself besieged and all sorts of links to sites contradicting your views appear. I think you will find that all of the Links are probably Footnotes in some book or other which espouses a different view.
Oh, and if it looks like you are winning, believe me, reinforcements will enter the fray to Prove that you are wrong. They will form tag teams which will attempt to inundate you.
Good luck and keep those comments coming.