Is the Fed About to Go Nuclear?

by: The PolyCapitalist

"We cannot stress enough how strongly we believe that a cliff-edge may be around the corner, for the global banking system and for the global economy. Think the unthinkable."

- Andrew Roberts, Credit Chief, Royal Bank of Scotland (NYSE:RBS)

(Note: this article is aimed in particular at individuals that are not as familiar with concepts such as quantitative easing, inflation, deflation, and what all this talk of 'printing money' means. These concepts can appear complex and intimidating, but they are not beyond reach of non-economists. Further, they are incredibly important to everyone. My hope is that you will take the time to learn more about this important topic and click through to some of the background info links I have included.)

The latest installments from the Telegraph's Ambrose Evans-Pritchard, who has been dutifully chronicling and predicting quite accurately the unfolding global financial crisis, suggest the U.S. Federal Reserve may be about to double down on its massive money printing campaign.

On Thursday Evans-Pritchard reported that an "epochal battle behind the scenes" is taking place at the Fed. The Fed may be on the verge of activating an additional $2-3 trillion in 'quantitative easing' (aka and hereafter referred to as either 'money printing' or 'printing money').

The Fed's new campaign would be on top of the nearly $2 trillion already printed by the Fed in the last 18+ months in response to the autumn 2008 financial crisis. The effect would be to balloon the Fed's balance sheet to a staggering and unprecedented $5 trillion -- approximately one third of annual U.S. Gross Domestic Product (GDP).

What does this all mean? Will this stave off deflation, trigger inflation, or possibly lead to hyperinflation? And what do these words mean in plain english for those who have never lived through a significant inflationary or deflationary period?

What is Inflation?

When the Fed prints money it may increase the likelihood of inflation.

But what exactly is inflation? It's a word that gets thrown around a lot, but it's often misunderstood.

While many people in developing economies throughout the world (e.g., Argentina) are all too familiar with inflation, in the U.S. my generation (Gen X) and everyone in Generation Y have either never lived through or were probably too young to recall the last significant inflationary period in the U.S. (early 1980s).

Inflation is simply a matter of supply and demand. It occurs when an increase in the supply of money (which I'll touch on in a moment) leads to more dollars chasing the same supply of goods and services. This in turn leads to an overall increase in the prices of goods and services.

How does the supply of money change, and where do these "more dollars" come from? This concept is a bit complex, but for a further explanation of the supply of money see this article. To summarize, the banking system in conjunction with the Federal Reserve control the supply of money. When the Fed prints money, as it has already to the tune of nearly $2 trillion and is contemplating doing again, it can lead to an increase in the supply of money.

Inflation: An Example

What happens when there is inflation? Here's a simple example:

If annual inflation were running at a uniform 33%, then a gallon of gasoline which costs $3 today would cost you $4 one year from now. In other words, an identical gallon of gas would cost you an extra $1, or one-third more, a year from now.

But a 33% increase in just the price of gasoline is not inflation. The reason is as follows:

Prices of individual goods and services go up and down all the time. If the supply of money is constant, and we have to spend more money on gas, then we have less money to spend on other goods and services. This would lead to a reduction in demand and lower prices for other goods and services. In this way the higher price of gas and resulting lower price of other goods and services more or less offset each other.

In our gas example, a 33% annual increase in the price of gasoline while large may not be an insurmountable burden. But it can be absolutely devastating (particularly to savers) when there is a 33% price increase in not just gas, but also food, clothing, healthcare, housing and every other good and service we consume. That's inflation.

Will There Be Inflation?

So we know that the Fed has increased the money supply by nearly $2 trillion, and we understand that inflation is triggered by an increase in the money supply. So surely inflation must be what the Fed and we should worried about, right?

Not necessarily.

The majority of the Fed's leadership (there are dissenters) bigger concern right now is deflation, which is the opposite of inflation. Deflation is characterized by a general decline in prices due to a decrease in demand.

So Here Comes Deflation?

In both April and May there was a decline the Consumer Price Index (CPI). CPI is the primary measure that the Fed uses to monitor prices for either inflation or deflation. The back-to-back monthly declines in CPI signal that deflation may be gaining momentum.

Ok, so we should be concerned about deflation?

Well, again, not necessarily.

Fed Chairman Ben Bernanke's Eerie 2002 Speech

In an incredibly prescient speech delivered on November 21, 2002 to the National Economists Club, a then newly appointed Federal Reserve Governor Ben Bernanke (now the Chairman of the Fed) delivered a talk titled Deflation: Making Sure "It" Doesn't Happen Here.

In his speech, Dr. Bernanke discusses deflation and various options available to the Fed when interest rates have reached the "zero bound" (also known as a 'Zero Interest Rate Policy' (ZIRP)). While it's debatable whether we have deflation or not, what is not debatable is that we have a ZIRP.

(The full text of Bernanke's speech, which is relatively non-technical and I highly encourage you to read, can be found at this link.)

As background, Dr. Bernanke is considered by many to be one of the foremost experts on the Great Depression, which was the most recent major deflationary period in the U.S. During the height of the Great Depression annual deflation was running at 10%.

Further context for Bernanke's speech is the case of Japan, which for approximately the past 20 years has experienced overall sluggish economic performance and deflation on the order of roughly 1% per year.

Ben Bernanke and the Printing Press

With the onset of the financial crisis and the U.S. setting a zero interest rate policy, it should be clear why Bernanke's 2002 speech has become quite famous.

Perhaps the most oft-quoted line from Dr. Bernanke's speech is the following:

"the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost."

It is this quote which brings us full circle back to the news of the day that the Fed may be about to set off another massive round of money printing.

Bernanke has been very consistent about his desire to avoid deflation. Further, he has previously spelled out that in fiat monetary regime like the U.S.'s there is no reason to ever experience prolonged deflation, like Japan's.

The Federal Reserve's Deflation Fighting Playbook

In a ZIRP environment like we have today, how did Dr. Bernanke propose we address the risk or event of deflation?

In short, by printing money.

To stave off or reverse deflation the Fed could take steps far beyond what has occurred to date (the purchase of U.S. Treasuries and Agency Debt). Additional steps Bernanke outlined in his speech include:

  1. Purchase of state and local government debt (e.g., California municipal bonds)
  2. Purchase of foreign government debt (e.g., British Gilts)
  3. Purchase private sector debt (e.g., corporate bonds).

And if you read his speech you'll see there's even more.

To be clear, some or all of these steps should with enough time in theory stave off or reverse deflation. But 'success' at defeating deflation may trigger other significant risks.

The sums of money combined with the various instruments the Fed is considering purchasing take us into what would appear to be unchartered territory. As such, should these actions take place it is impossible to know what the results and side effects may be.

However, there are very likely to be unintended consequences. Some very real negative possibilities that could play out over varying degrees of time include hyperinflation, a dollar collapse, the loss of the U.S. dollar's status as a reserve currency, among others.

In Closing

As always it's unclear what the future holds. Whether or not the Fed will in fact take these steps, and what the exact results would be, are not easy to predict.

Throughout history when faced with the prospect of extreme government currency and market action like what's been discussed in this article, individuals have often sought financial protection by shifting into hard assets such as gold. And certainly the price of gold suggests that this in fact is what is underway.

Gold has recently been hovering around an all-time high (in non-inflation adjusted price terms). Whether or not gold is already in bubble territory is debatable, but there are compelling arguments that it is not. A bullish indictor: central banks such as Saudi Arabia's, Russia's, and others have been actively purchasing gold. Interestingly, when Ben Bernanke was recently asked in a congressional hearing about the rising price of gold he seemed puzzled, from which the reader may wish to draw their own conclusions.

And Gold is not necessarily the only asset you should evaluate. For example, you may also want to consider Silver.

It should be noted that gold, as with most commodities, is a volatile asset and capable of extreme price swings. You should think carefully whether or not an investment in gold (or any commodity) is the right answer for you based on your time horizon, expectations, and risk comfort.

Disclosure: Long Gold and Silver