Thoughts on 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 the 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 the other day, 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.

Disclosures: Paco is long gold.

Copyright 2009, Paco Ahlgren. All Rights Reserved.

Comments

[JohnAl:]

I think you may be right. The new money may flow into the economy only slowly, since borrowing demand is low and may remain low while individuals and businesses save and cut costs. But the inflow of new money should raise the general price level anyway, at least to the degree that it exceeds any further credit contraction still taking place. I'm not sure that I agree that prices will rise rapidly though, since in this scenario the new money flows into the economy slowly.

Also, there IS something that government CAN do to help, though the likelihood that they will do it is absolute zero. They could cut taxes and CUT spending. The benefit of cutting taxes is obvious. Taxpayers would be more flush. They'd save more and they'd spend more. Cutting spending, I contend, would also help because it would send a powerful signal to investors that the US government is serious about putting it's fiscal house in order.

Of course cutting spending is not going to happen since Keynesianism predominates political thought at the moment. And it's true that cutting spending WOULD hurt those who would have received the spending, but as far as the general economy is concerned it would simply be putting the purchasing power back into the hands of those who earned the money - the rightful owners.

Feb 03 04:55 AM

[strutzma:]

Do you see any chance that the current economic uncertainty will induce a significant increase in the savings rate, back to the rate(s) in the early '80s following the last bout of stagflation? This may be the only way to stem the rapid inflation you have otherwise indicated, however I would like your input on this possibility...?

Feb 03 05:29 AM

[Paco Ahlgren:]

I don't think people will have any choice but to save once the Fed's chicanery yields its ultimate result. But I think the savings rate will take a long time to get there. De-leveraging will be the status quo for some time...

Feb 03 08:39 AM

[Balderdash:]

Great article. You've highlighted the predicament of the fed's mandate and the inevitability of failure given its conflicting goals.

Feb 03 08:47 AM

[patio:]

Credit is hardly easing. I have a near perfect credit score, i have had certain cards for over 20 years, and I pay them all off every month. I just received notice of my rates going up, and maximum coming down.
I am currently refinancing, I have a 4.75 new loan locked in, but the process is taking much longer as they have their microscope way up my derriere. As it should be, by the way.
I am still employed, in Austin, where the unemployment rate is a few points lower than the US, and everyone I know is not buying, not even thinking about taking on any new debt, and saving and shopping very carefully.
So your primary premise of this tidal wave of money and credit hitting deluging the economy is completely and uttterly flawed.
If consumers, and companies, neither WANT to borrow and are not ABLE to borrow regardless, no increase in velocity, no deluge, nada.
And there is nothing unique in your analysis, no new thoughts. So why hasn't the T-bill already tanked, why hasn't TBT and gold sky-rocketed, why is the dollar ever stronger vs. all currencies save maybe the yen?
Everyone is stupid I guess except you.

Feb 03 09:51 AM

[Jimbo:]

Paco is "right on time". Cost-push inflation is already here: walk through any grocery store and note prices and the size of containers and packages.

Feb 03 09:58 AM

[patio:]

Where do you shop? Every store I see has 40-60% off, on everything. My grocery bills have never been lower. I can't believe the price of beef, NY steaks for $3.99/lb. Granted, groceries by and large have not deflated as much as anything discretionary, essentials still have some degree of pricing power. As further job cuts and company retreactions work their way through, demand destruction just keeps increasing.
If you think there has not been complete seachange in consumption attitudes, then go ahead and believe in the coming inflation theories- they are not unique, and you can read 5 a day by different bloggers here at SA. Most of them pushing gold.
Most estimates have a now $12T going to $15T wealth loss, just here in the US- now add in worldwide wealth losses. Now add cash flow losses due to unemployment.
Who is going to be borrowing, and to buy what?


On Feb 03 09:58 AM Jimbo wrote:

> Paco is "right on time". Cost-push inflation is already here: walk
> through any grocery store and note prices and the size of containers
> and packages.

Feb 03 10:23 AM

[Tetrapod:]

Another excellent article, Paco!

Patio, I think you are right about credit not having eased yet, but I believe this is intentional on the part of the Fed. Why are they paying interest on bank deposits with the Fed, which they've never done before? To sequester the funds until they've all been deployed and ready (and until some of the deficit has been funded at low interest rates).
When they're ready, they'll remove the temporary interest on those funds and the banks will be forced to find a home for them in the economy. The Fed has got to be counting on a sudden inflationary shock to set the economy in motion, like a shot of adrenaline. A slow roll will not do much for the economy and the Fed knows it.

By the way, TBT is up over 30% since Christmas Eve 2008 (~40 days). Some might consider that "Sky Rocketing".

Feb 03 11:18 AM

[patio:]

"When they're ready, they'll remove the temporary interest on those funds and the banks will be forced to find a home for them in the economy"
You can't force borrowing, you need two sides to that equation. Consumers are tapped out, they have bought forward all the discretionay crap they will ever need. Companies don't borrow to expand their businesses when there is no demand.
I don't think many of you comprehend the degree of demand destruction, that is the result of decades of easy credit. Just consider the following as possibilities:
- cars actually last 200,000 miles, don't need to buy every 3-4 years
- maybe just maybe 3 TV's per household is enough
- my computer does everything I ever want it to do
- I really don't need bottled water, $4 coffee, lawn service, maid service, etc.
- other than traders, the market may just have lost a lot of people, forever, and others for a very long while
- boomers, who would be downsizing about now anyway, are downsizing on steroids.

I see a recipe for very long-term attitudinal change in consumption. We'll see.
-



On Feb 03 11:18 AM Tetrapod wrote:

> Another excellent article, Paco!
>
> Patio, I think you are right about credit not having eased yet, but
> I believe this is intentional on the part of the Fed. Why are they
> paying interest on bank deposits with the Fed, which they've never
> done before? To sequester the funds until they've all been deployed
> and ready (and until some of the deficit has been funded at low interest
> rates).
> When they're ready, they'll remove the temporary interest on those
> funds and the banks will be forced to find a home for them in the
> economy. The Fed has got to be counting on a sudden inflationary
> shock to set the economy in motion, like a shot of adrenaline. A
> slow roll will not do much for the economy and the Fed knows it.
>
>
> By the way, TBT is up over 30% since Christmas Eve 2008 (~40 days).
> Some might consider that "Sky Rocketing".

Feb 03 11:59 AM

[carey_jim:]

Your pessimism about America can be extended to the rest of the world just as the history of the 20th century can be extended into the 21st century:

During the 21st century, all over the world, including in the United States, there will be massive wars, revolutions, genocides, starvation and crippling new diseases.

There will be dancing around the golden calf and ignorance of the arts and sciences of the previous generation.

'you generation of vipers, how can you escape the damnation of hell?'

This refrain has been with us for at least 3000 years.

We can hole ourselves up in fortified citadels stocked with gold, or roll up our sleeves and fight, together, against the imagined demons of our future.

Whatever the case, we can't know if the next comet to appear on our horizon will be a lucky one or an unlucky one or if it will appear at all.

So let's take off our pointed hats and call a truce.

Feb 03 01:58 PM

[SeekingTruth:]

I coined a new word for myself early in 2007. I call it "Crestflation".
This is similar to a river that has crested and continues to do great damage even if the water level is not rising any longer, or only rising a little, like current inflation numbers.

There have already been a great number of people that have been driven into poverty by steady inflation that has "crested", and it only takes a "little" more inflation to claim more victims. And , so , in my view, we have a curious mixture of stagflation, crestflation, deflation, and disinflation all in the mix and creating a riptide of crosscurrents that are tearing the economy asunder.

And so , to the ordinary citizen, it doesn't matter much if he has "some" money , but can't afford the extremely high prices, or is faced with lower prices that he has even less money with which to purchase necessities.

Either way, he doesn't have enough money.

Still, if choices have to be made (and they do), an investor must now guard most against inflation in the longer term, while wrestling with stagflation in the short term. One of the best ways to do this is try to buy commodities when they are low, and good growth stocks, along with some good dividend paying value stocks.

Right now , I favor the commodity stocks/ETF's over other stocks, whose day is approaching somewhere down the line, which gives us time to be choosy, notwithstanding the long anticipated deep oversold exhaustion rally expected faily soon.

However, unlike in past cycles, we must take profits more quickly, and be patient waiting for other good opportunities, they aren't going away, although it doesn't seem that way sometimes.

Feb 03 09:47 PM