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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

Source: The Inflation Time Bomb