Is Inflation a Fact… Or Just Opinion? Part 3

Today, we’re going to complete our three part series re-evaluating the common arguments for inflation. If you missed the first parts of this series, you can review Part 1 here and Part 2 here.

Thus far we’ve shown that inflation has NOT yet gripped the market despite the public’s beliefs it has. Commodities remain nowhere near their 2008 highs (oil is currently entering a sharp correction) and the dollar is actually higher than it was BEFORE Bear Stearns. Both of these indicate inflation has yet to come home to roost.

So what’s the deal?

For starters, we need to address the most common misconception pertaining to the Fed: that of “money printing.” The Federal Reserve doesn’t actually “create” money. It issues debt and lends money out (like any bank), but it doesn’t just give money away.

Where does this money go?

Onto US banks’ balance sheets. And it only translates into inflation if the money flows into the US monetary supply (the actual money in circulation, as opposed to the money base which is a measure of money left in banks’ vaults and reserves).

And it isn’t.

US banks are not lending the Fed's money out. It is NOT entering the US money supply. Why? Because the banking system is essentially insolvent, or would be if it marked the assets on bank balance sheets anywhere near the price said assets would fetch on the market. In simple terms, banks have too many debts or liabilities and need to raise capital. They are doing this in three ways:

§ issuing more shares

§ dumping liabilities on the Federal Reserve’s balance sheet

§ hoarding the Feds’ low interest loans.

This analysis is often left out of most inflationists’ forecasts: that the Fed's money lending isn’t actually getting into the economy because banks are hoarding it. The below chart shows reserve balances with Federal Reserve banks. In simple terms, this shows how much money is sitting on banks’ balance sheets in excess of what they’re required to maintain. If you’re wondering where the $900 billion that the Fed has been printing is ending up, look no further (BTW, the gray bars on the chart indicate recessions).

This situation is not going to change any time soon. The easy money and loose credit standards maintained by Alan Greenspan for 20+ years allowed banks, consumers, and companies to take on a truly staggering amount of debt. All told, total private debt is currently 350% of GDP or $49 trillion. To put this number into perspective, it’s far, FAR greater than the percentage of credit debt relative to GDP that put the US into the Great Depression.

Already insolvent, banks have absolutely no incentive to increase their lending. They need to raise capital (hoard cash) and lower liabilities. So giving out money to consumers or businesses (especially during a recession when earnings are falling due to the slowdown in consumer spending and the rise in unemployment) is the LAST thing they want to do. This is most obvious in the fact that credit card mailings are at their lowest levels since 2000. Indeed, credit card mailings for the first three quarters of 2009 were HALF of those mailed in the last three months of 2008.

Anyway, it’s not like consumers or businesses WANT to take on more debt. In fact, they’re doing the same thing as the banks: trying to pay off debts and raise capital. For consumers this has translated into two trends:

§ Increasing savings

§ Paying off debt

According to the Bureau of Economic Analysis, personal saving as a percentage of disposable personal income was 5.7% in April, up from 4.5% percent in March. Remember, this stood at 0% only four years ago.

Consumers are also paying off debts in record amounts. All told, Americans have paid off $40 BILLION in credit card debt since February. Those who cannot pay off debts are simply choosing to default: credit card defaults at Citigroup, Wells Fargo, and American Express are all at 10%, meaning it’s very likely that $1 out of every $10 in credit card debt will NEVER be paid back.

There’s another reason banks aren’t lending, that being that lending standards have risen dramatically. With unemployment rising, consumers still in debt up to their eyeballs (despite paying some of it off), and household net worth plunging ($11 trillion lost in 2008 alone) the banks’ number of potential loan applicants has shrunken dramatically.

Thus we see the gaping hole in tradition inflationist claims that money printing = dollar debasement and rampant inflation. The Fed is loaning out money as fast as it can… but banks aren’t letting that cash get into circulation. And consumers don’t want more debt anyway.

These are all facts, not opinions. And they go a long way towards explaining why the dollar is actually stronger now than it was before Bear Stearns AND why commodities are not soaring past their former highs.

Instead, what we are witnessing is a slow motion deleveraging and recapitalization of the world financial system. Banks are trying to put off marking their assets to market so they can continue to perpetuate the illusion that they are solvent while raising capital. Consumers are paying off personal debts or defaulting (something the banks cannot afford to do). Thus the trillions of dollars the Feds are pumping into the banks are not entering circulation, thus inflation has not taken hold.

Bottomline: Inflation remains a very real future threat… but it is not here just yet. Setting up some inflation hedges now is not a bad thing, but you need to be prepared to hold for the long-term (at least upwards of a year). Gold is the ideal hedge since it performs well during both inflation AND deflation.

Good Investing!

Comments

[Craig W:]

Great article. The deflationary forces are very strong, but as long as the banks maintain the huge reserves at the Fed, inflation will remain a threat. The banks are paying interest on those Fed loans . . . even if it is at a really low rate. At some point, the banks will have to repay the loans, deploy those funds to realize a positive return, or slowly bleed to death. Even a small interest rate, when applied to a TRILLION dollars, begins to add up to BIG numbers.

As I commented on your first article in the series, I'm still not sure you showed that the public believes inflation has taken hold. The “folks” behavior of increasing savings and paying down debt is the opposite of what one seriously fearful of inflation would do. Perhaps it's a minor point, but it would be great to see some public opinion polls or something to quantify the inflation expectations of “regular people”. TIPS yields indicate that the market is not pricing in significant inflation.

Jul 07 01:50 PM

[cameroni:]

Thanks Graham, It is an interesting treatise on the future strength of the dollar. I just don't agree with it.

What about unfunded liabilities?
What about the raft of retirees and all the benefits they are entitled to?
Who will pay for all the new Medicare obligations?

Do you think that the Fed will stand by as California and other "at-risk" states and municipalities default, even bankrupt and turn out the lights, eliminate services, cut teachers, police, fire protection, air traffic controllers, garbage collection etc?

Where do you think the money will come from if there is another war?

How will all the benefits be paid at the state level for Welfare when states have run out of funds? Will the liquidity be withheld then?

Who will pay the growing costs of unemployment benefits........?

There will be a release of liquidity. It may not be to the originally targeted middle class consumer and homeowner but the money will be released at the behest of the administration. The alternative of widespread unemployment, potential civil unrest as the newly disenfranchised organize and assert themselves is too risky to contemplate.

There will therefore be a massive dollar devaluation as monetization substitutes for real borrowing and all the gaping holes in the budget are filled with smaller and smaller dollars. There will be severe inflation and I fully expect a hyperinflation that will wipe most debt off the ledgers, destroy much of the financial, banking and insurance system as we know it and and finally bring on the real correction the system needs to begin functioning again.

Jul 07 08:40 PM

[Poborsky:]

"For starters, we need to address the most common misconception pertaining to the Fed: that of “money printing.” The Federal Reserve doesn’t actually “create” money. It issues debt and lends money out (like any bank)"

"If you’re wondering where the $900 billion that the Fed has been printing is ending up"

Maybe you could clear this up, because you seem to contradict yourself . If the FED issues debt, where does it get this debt from. If it creates it then it is printing money and lending this created money at interest. Making itself money out of nothing in two different ways. If the banks have borrowed this money then they have done so to create an illusion that they are solvent. They would have to do this by more creative accounting. Why would they borrow money then leave it in the vault?

The main cause of hyperinflation is a loss of confidence by the market in a countries currency. Generally this is brought about by running fiscal deficits for many years, then when a recession appears tax revenue falls and the govt tries to spend and print its way out of trouble causing a spiral effect.

Jul 08 09:23 AM

[Dirk McCoy:]

I don't believe we'll see significant inflation based on the spending of welfare and Medicaid recipients- and without them, you'll see more deflation.

Credit has been destroyed at a gargantuan pace, and only a gargantuan recovery of long term confidence and credit has the potential to create inflationary pressure that cannot be dealt with by substitutionary goods and services, economies of scale, or additional capacity. And nothing is happening to create long term confidence right now.

Jul 10 12:32 AM