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Twinkie defense is a derisive term first coined in a murder trial 34 years ago. The defense lawyers in the case claimed that consumption of the sugary snack led to a diminished capacity to distinguish right from wrong and to think clearly. After a brief turn into bankruptcy and installation of a new management, Twinkies are finally back on store shelves and apparently being gobbled by economists of almost every persuasion, but it seems in especially great quantities by those at the Fed and other central banks.

How many times has the mantra been repeated in the financial media that there's been no inflation to speak of, that the Fed has plenty of room to extend its easy-money regime, and that the Fed only wishes that it could boost the rate of inflation to maybe as high as 2% per annum? If it's so generally accepted, it must be true. Right?

Well, the "core" inflation headline number that excludes the "volatile" food and energy components would support this happy story. And so would the Fed's proprietary PCE chain deflator methodology which makes inflation appear to be relatively tame.

But let's get real. Unlike the New York Fed economist who a few years back was so impressed with the declining costs of iPhones (in a hedonic sense), real people need to pay for food and energy every day. Real people can't at all buy into the no-inflation story.

We don't have to go back to ancient economic times to see this. Let's only go back to the start of the last financial crisis in 2007, only six rocky years ago. For one, even though the suggested retail price of Twinkies has over this time ostensibly remained the same at $3.99 for a box of 10, the new smaller package weighs each cake at 38.5 grams as compared to the previous weight of 42.5 grams. So, all Twinkie lovers are now getting around 9.4% less for their money. Sounds like inflation to me.

Let's now look more seriously at a few other selected examples from the Bureau of Labor Statistics All Urban Consumers (CPI-U) series for which 1984=100 (except where noted):

2013 (June)

2007 (Annual avg)

% Change

All Items:

233.504

210.036

11.2%

Food & Bev.

236.726

206.936

14.4

Meats

233.883

195.558

19.6

Fuels & Utilities

230.506

203.006

13.5

Transportation

220.044

189.984

15.8

Medical Care

424.264

357.661

18.6

Education*

222.158

176.927

25.6

*Base 1997=100.

Oh sure, a few items (not shown here) have gone down in price and provide more for the same money. Call these iPad/smartphone-type products. But for the major real world life-critical items, the average annual rate of inflation over the last six years has exceeded 2%, in some cases by a large amount and even over the course of what's generally been a lackluster and lethargic economic "recovery" that would ordinarily subdue any tendency or ability to raise prices.

The Fed's tone-deaf and blind economists and those outside who repeat the no-inflation mantra should only wish that inflation has been as low as 2%. A compound rate of 2% inflation doesn't sound so bad, but a little arithmetic shows how even 2% per annum leads to larceny on a grand scale; a dollar losing purchasing power of 2% a year over 10 years will at the end only buy around 80 cents worth of goods! This is devastating for current and soon-to-be retirees because it silently steals and secretly confiscates -- to paraphrase Keynes of around seventy years ago -- a life's worth of savings. Bye-bye nest-eggs.

The Twinkie defense, however, goes far beyond this "no-inflation" theme so often expressed in the media by professional economists who should know better. Take, for instance, the tapering talk. In late May, "we're thinking of tapering," says the Fed. But by late July, the Fed says, "gosh, we really didn't mean it… Mr. Bond (market) please go back to a 10-year treasury yield of under 2%, please.

And furthermore, don't you unruly, thick-headed bond vigilantes understand that our decisions are from now on all going to be "data-dependent." Huh? Haven't they always been?

The headline inflation numbers every month seem to have so swayed, impressed, and anesthetized the mainstream economists that they no longer think the data shown above has any relevance. But if policy were indeed dependent on those data, no versions of QE or of forever near zero interest rates would have been allowed. Inflation for real people would be a lot lower than it is now. And retirees and their pension plans would not have been compelled to so riskily participate in what will in retrospect come to be known as the great yield-chasing bubble of 2011-13.

Moreover, if the Fed's balance sheet is at $2 trillion going to $3 trillion in a year, and QE4 monthly purchases remain the same at $85 billion a month, then, arithmetically, the Fed has already been tapering for most of this year. So as to remain proportionately expansive and to not taper, monthly purchases should have already increased by an average of about 4% every month and should now be close to a run rate of $130 billion a month.

It's a geometric progression locked on a course to infinity and beyond (see "Cooking Up a Crash" of June 14) -- a course of destruction that the central banks cannot end without ultimately doing severe damage to the markets, the economy, and ultimately the credibility and "independence" of central banks themselves. Any notable pick-up in economic growth and/or headline inflation in the U.S. will now quickly translate into rising yields because the debt markets are ideally primed and positioned for this to happen.

However, while this is happening, dreaded deflationary conditions are most ironically starting to exert a tightening grip over broad swaths of the world's economy. Prices of gold, copper, oil, and the Baltic Dry Index, for example, are all below those of a year ago. And bond prices -- including munis such as Detroit's and those of eurozone and emerging market countries -- have begun to again decline sharply. This is not at all because of fears of inflation but because it's becoming increasingly obvious that -- even should there be a modest pickup in economic growth -- the underlying ability to service many already existing massive debt obligations is becoming ever-more questionable (e.g., real-estate bubbles in China and Canada). The time for amend, extend, and pretend is quickly drawing to a close.

Despite massive central bank interventions, net credit creation around the globe thus appears to be either shrinking or poised to shrink even while financial market leverage builds for the only reason that the Fed is still pumping and presumably still has everyone's financial back. The lesson that will sooner rather than later be abruptly and abundantly learned is that they have your back until they don't. Thus the "no-inflation" economists will likely turn out to be right, but for reasons and in scenarios that they do not and cannot currently envision.

There are many other Twinkies left in the box to chew on but not necessarily digest well. For example, why has the Fed complicated things by targeting an unemployment rate on which it has little if any direct or immediate effect? The goal posts on this seem to move with every month's report, fogging investors' windshields even while the central bank proclaims the dawning of a new era of "transparency." And then, what is the real unemployment rate? As with inflation data, the headline numbers do not seem to tell the full story.

For now, I've had my fill of Twinkies. Maybe the next Fed chairperson might make better decisions snacking on Ding Dongs. I hear the price hasn't yet been raised.

My recommendation is to stay long the ProShares UltraShort 20+ Year Treasury ETF (NYSEARCA:TBT), which rises along with treasury bond yields, be increasingly long the iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX) as complacency is rampant now that the S&P has risen 16 out of the last 19 days, and short junk bonds using the SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK).

Source: The Fed's Twinkie Defense