Inflation: Making Sure It Doesn't Happen Now

Includes: CEF, TLT, UUP
by: Jason Tillberg

At the age of 48, Ben Bernanke gave a speech titled "Deflation: Making Sure "It" Doesn't Happen Here," back in November of 2002. In his speech-- which is worth a read-- he spoke about what the Fed could do to prevent deflation, even when interest rates were at zero percent as they are now. He spoke about "printing money" with our electronic printing press as a means to prevent deflation if need be.

Inflation was quite low in the beginning of 2002, running at just over 1% as the nation was recovering from the tech and manufacturing recession. Under Fed Chairman Alan Greenspan, the Fed dropped the Fed funds rate from over 6.50% in 2000 to just 1.01% by July of 2003. The following actions of the Fed speaks for itself in the chart below.

Note: Ben Bernanke was appointed Chairman of the Fed on February 1st, 2006 by then President George Bush.

Below is a chart of the rate of inflation starting just before Ben Bernanke gave his deflation speech. As you can tell, inflation picked up from 2002 and made one last surge in the summer of 2008 to over 5% before crashing to a negative rate of inflation, which would be called, "deflation." So much for making sure it never happens here.

Recently, the rate of inflation is dropping again, down to just 1.1% year over year as of this past April. With the bout of deflation that occurred in 2008 and 2009, Bernanke followed through on his intentions that he said he would do to prevent it from "happening here."

In his speech, he talked about what else the Fed could do if interest rates were at zero percent. He stated:

"The Fed can inject money into the economy in still other ways. For example, the Fed has the authority to buy foreign government debt, as well as domestic government debt."

Buy domestic debt they did. Here is a chart showing how much Treasury debt the Fed owns:

These securities are liabilities. The value of these securities is affected by the current rates of interest. If interest rates rise, the value of these securities-- especially longer dated treasury securities-- will fall in price. The bigger the rise in rates, the bigger the fall in value.

Economic historian, Martin Armstrong, wrote in his blog on January 3rd, 2013 after the Fed's December meeting minutes were released, that the Fed's concerns were to shift to worrying about the bond market and that those concerns would be bearish for gold. I sold my gold and silver fund Central Fund of Canada (NYSEARCA:CEF) after reading both the minutes and Armstrong's post, and have not bought any back since.

This is what Armstrong said on January 3rd, 2013 about those minutes:

"The news pundits call the minutes from the Fed's December policy meeting showing a growing concern about further increases in the central bank's $2.9 trillion balance sheet since 2007-2009 a "surprise" for Wall Street. Quite frankly, how could anyone take QE3 seriously as being open-ended when it was announced before the elections? Come on! You have to be joking not to have seen through this timing.

Of course the Fed will slow or to stop purchases well before the end of 2013, citing concerns about financial stability and the size of their balance sheet. The elections are over. They did their job. It is time to get real. The Fed is concerned about the bond market - not main street America. The Presidency will change in 2016 and they will be gone so there is no incentive to worry about the economy. It' the debt!

The Fed is concerned that if interest rates rise because of inflation, the balance sheet will tank. The Fed will shift now to be more concerned about the bond market. The crisis they face is rates are so low, even a quarter point up tick will be devastating for the bond market."

Note: bold emphasis mine

Two things worth noticing now. Since May 1st, interest rates are on the rise. Here is a chart of the 10 year Treasury yield:

Aggregate demand for money, credit, has been on the rise per this chart of total credit owed year over year percent change:

This chart above only goes out to the 4th quarter of 2012. We'll get the Q1 of 2013 next week. If demand for money is on the rise, then that would likely be a good reason for interest rates to rise. As of April, it certainly appeared the inflation dragon was well under control. However, interest rates jumped hard in May. It will be interesting to see what May's inflation rate looks like.

Regardless, the Fed is worried about the Bond market and interest rates as Martin Armstrong indicated, and this rise in interest rates may well bring out the hawks to attempt to tamper rates from rising too much, I would think.

Because rates have risen so much in the month of May, longer term bonds (NYSEARCA:TLT) have been hit hard. Most important perhaps, the Fed's balance sheet was hit hard too. According to the popular blog, Zerohedge, the Fed lost $115 billion or 3.5% of its total balance sheet of some $3.4 trillion in May. The situation is, given this entire "Faustian Bargain" as I liken it to be, there are always to be unintended consequences when you make that bargain. Faust actually made that bargain of printing money in book II!

Per the Fed's May 17th Minutes:

"There are potential risks associated with current policy. The Fed's securities purchases have reduced mortgage yields and, to a lesser extent, Treasury yields. Current low bond yields are disruptive to management of fixed-income portfolios, retirement funds, consumer savings, and retirement planning. They may encourage unsophisticated investors to take on undue risk to achieve better returns. MBS purchases account for over 70% of gross issuance, causing price distortion and volatility in the MBS market. Fixed-income investors worry that attractive mortgage-backed securities are in very tight supply. Higher premium coupons carry too much exposure to prepayments, potentially led by new government support programs for housing. Many are concerned about the Fed's significant presence in the market. They have underweighted MBS in favor of corporate, municipal,and emerging-market bonds. There is also concern about the possibility of a breakout of inflation, although current inflation risk is not considered unmanageable, and of an unsustainable bubble in equity and fixed-income markets given current prices."

Note: Emphasis mine

A breakout of inflation, with rates as low as they are, would set the barn on fire. How to invest if the barn is burning down is not going to be easy. Inflation threats are surely to be dealt with by the Fed in no time given their balance sheet risk. So, I would think inflation risks are very low. We face serious risks for sure. In the near term, I like the U.S. dollar (NYSEARCA:UUP) and just plain cash outside of investments anyone can make in their own home economy.

I do wonder, given the tremendous interest rate risk the Fed now faces, if Ben Bernanke were to give a new speech today, would it be titled: "Inflation: Making Sure It Doesn't Happen Now."

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.