The Fed Brews Inflation

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by: Jim Mosquera


A nickel ain't worth a dime anymore.

What is the Fed doing behind the curtain?

Will gold play a role?

"A nickel ain't worth a dime anymore." Those were the memorable words of Lawrence Peter "Yogi" Berra. It was his way of explaining inflation. As I noted in Chapter 2 of Escaping Oz, people experience inflation as an increase in prices. Those price increases could result from a supply-demand condition. For example, if a cold spell hit the orange growing region in Florida, wiping out the majority of the crop, it stands to reason that consumers will experience higher prices for the fruit and its byproducts.

There is also monetary inflation. This is the creation of credit in excess of the wealth or goods and services in the economy. Monetary inflation is a product of the commercial banking system and central banks. This type of inflation has been the central bank strategy since 2008. The strategy can assume the form of buying government bonds, mortgage-backed securities, and in other countries, outright intervention in equity markets. Our central bank often discusses having a 2% target inflation rate, which may in fact need to be higher since the rate has been below the target.

So why would central bankers work so hard to make sure a nickel ain't worth a dime anymore? This is because a central banker's greatest nightmare is monetary deflation, where the amount of outstanding credit decreases. Consumers will experience this as falling prices (Note: I'm not referring to lower prices due to technological innovation or productivity improvement). But before you have deflation, you need inflation. I often refer to investment cones as funnels for excess credit. That excess credit tends to chase financial assets and form speculative bubbles. I postulated a couple of economic laws that address deflation.

There are psychological components at work also. During a deflation, consumers are reluctant to spend or acquire new debt and lenders are less eager to lend (or may be constrained). Inflation creates the opposite effect. Consumers are eager to spend the diminishing value of their money. Deflation produces low money velocity and inflation does the opposite. We are in a decidedly low velocity period.

There is another important reason why central banks want to diminish the value of Yogi's money and that has to do with a four letter word D-E-B-T. Our official government debt is north of $19 trillion and other liabilities are multiples of that. The U.S. is not the only country in this debt predicament. With deflation, paying off this debt, which is already impossible, is even more impossible (if that's possible).

There are three ways out of a debt crisis: grow, default or inflate. Economic growth would allow for the orderly payment or at least servicing of all debts. Our economy has not been growing as fast as our debt and headwinds to economic expansion remain. Default is a painful alternative for debtors and creditors, so much so that a presidential contender had to clarify his views on the notion of a default. Debt default recently occurred in Puerto Rico and very famously in Argentina. So central banks and governments turn to the more stealth alternative of inflation.

Our central bank, the Fed, has been trying this for several years now via QE, Operation Twist, near zero rates, and benign forward guidance. This approach was thought to promote inflation and economic growth. It has not had the desired results. The extra money is resting comfortably in bank reserves or has percolated in financial assets. So the Wizards pulled another lever in the control room. I penned an article on this strategy being employed overseas and contemplated by the Fed, negative interest rates (NIRP). NIRP has enjoyed limited success in Japan, where it is most prevalent, so it is likely the Fed will need to look for a new button to push.

Helicopter money is a reference made by Milton Friedman in 1969 whereby he envisioned money falling from the sky, like manna from heaven, and people using the newly found paper to spend in the economy and thus raise inflation. But remember what I said about deflation being a psychological phenomenon as well. There is ample evidence that a great deal of that manna would be saved for a rainy day. So a more efficient transmission mechanism would be required to get that money actually circulating in the economy.

Alex, let's try Central Banking for $500 please.

An organization that frequently spends more money than it has.

Who is the federal government?

The government, presently, would be the best way to get this money into the economy via fiscal spending. This entails growing the deficit substantially through the issuance of more debt that would be purchased by the Fed. The extra spending could be directed towards infrastructure or green initiatives to combat global warming. The hope would be that money velocity would increase, inflation would increase, and that long-term, the debt problem could become more manageable. It remains to be seen whether such a deficit expansion could make its way through a Congress divided on budgets and global warming. So what if this approach fails?

The Fed wizards could reach back into the playbook from the 1930s whereby government swung for the fences, making gold illegal and purchasing it for the official price of $20.67/oz. Immediately upon securing the yellow metal from its citizens, the price was arbitrarily raised to $35/oz, representing a 70% increase. Now remember, gold has been cast as a monetary relic or a commodity. The reality is that gold has always been money. It meets all of my definitions of money (medium of exchange, a unit of account, and a direct store of wealth). The monetary authorities also understand this.

What might evolve under this scenario is not an outright confiscation of gold but something else. In a novel I will release next month called 2020, the U.S. government aims to get gold out of circulation by accepting payment of government debt (taxes, tariffs, fines etc.) with gold, but at a dollar value substantially higher than its market price. If the market price for gold was $1,000/oz, taxpayers in this fictional account could pay $3,000 of taxes with one ounce of gold.

Yet another approach would involve outright purchases of gold, once again well above the market price, by the Fed or perhaps indirectly through the federal government. Gold purchases above the market price would have the effect of increasing inflationary expectations. If you accept that gold is money and that more dollars (or the currency of your choice) are required to purchase an ounce, you have effectively devalued the currency relative to the ultimate money. Presto, you have inflation. This direct purchase approach avoids the messy currency wars that have been in effect for some time now that is a zero sum game.

The goal of the article is not suggest consent with these approaches but rather to point out what the Fed has done, and what buttons and levers they might push next. The Fed will continue to brew the inflation elixir. Poor Yogi may need more nickels after all.

Disclosure: I/we 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.