An increasingly vocal cohort of economists and analysts are sounding the fire-engine red alarms that hyperinflation is coming in the U.S., as early as this year or a decade out.
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Analysts at UBS, economists Allan Meltzer and John Williams, investors Marc Faber and Peter Schiff, and the gold bugs have repeatedly rang the bell about wheelbarrow inflation.
But betting the Fed’s stimulus slingshot will come back to hit us all in the head with hyperinflation anytime soon will make you broke.
The hyperinflation storyline goes like this: The Federal Reserve’s ultra-low interest rate policies, its mega-purchases of U.S. Treasuries and mortgage-backed securities, and the attendant increase in bank reserves will all leach into consumer prices in a big way very soon.
However, the Fed’s monetary big bang experiment will not immediately play out in hyperinflation, and it may never do so, not in the way inflationistas think—even though anyone arguing that risks being put in front of an intellectual firing squad.
Hyperinflation is not upon us, nor is it evident in Japan, even though its central bank went down this “stimulus” road in 2001 well before the U.S.
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“If reserve growth had any broader impact on bank behavior or the economy, Japan wouldn’t still be stagnating after more than a decade of its central bank stimulus, and the U.S. economy would have responded much more strongly to growth in its central bank’s balance sheet,” says Louis Crandall, chief economist at Wrightson Icap and a respected Fed watcher.
The Fed’s unstated “triple” mandate—price stability, maximum employment, and now asset reflation—has consistently been criticized for the last six years as a dangerous moonshot for job growth that will swamp the U.S. economy in hyperinflation.
The criticism comes as the central bank faces Congressional and White House pressure like never before—government spending being mistaken for achievement.
The Federal Reserve’s balance sheet has more than quadrupled to $4.4 trillion since the beginning of the economic crisis due to its large “quantity” of securities purchases (ergo “quantitative easing”).
The central bank created some $2.52 trillion in digital cash, or bank reserves, to first buy rotten mortgage-backed bonds, later U.S. Treasuries, off broker-dealer and bank balance sheets to keep borrowing costs low, which helped revive the housing market (loan rates tied to long-term bonds and notes) and created ‘trickle-down’ confidence.
Stocks rose in value, the upper brackets now spend more, and companies have borrowed cheaply to do things like buy back shares in record amounts, artificially engineering their quarterly EPS, and stock performance, performance higher.
The Fed is expected to make a final $15 billion securities purchase in October, with resulting market volatility, the bedfellow of natural market forces.
The $2.52 trillion in digital bank reserves have been sitting parked on the dozen Federal Reserve banks' balance sheets ever since the Fed began paying interest on reserves in October 2008 for the first time in its (then) 95-year history .
Crandall says: “The volume of reserve balances imposed on the system by the Fed only affects lending very indirectly, if at all.”
Plus, economists note the Fed has the power to destroy those reserves—though that is an extremely risky endeavor.
Instead, the looming black swan event is this: Who steps in when the Fed steps out of buying U.S. Treasuries starting this fall, which could spike the benchmark 10-year yield, and consumer borrowing costs, higher?
Foreign buyers, including China, lately have sent up smoke signals that they might be unreliable buyers of longer-term U.S. notes and bonds. And that is the danger.
Hyperinflation, extremely high and rapid price increases, is typically triggered by the actual creation of hard currency to pay for things like unfinanced wars or to calm social unrest.
An excess of fiat currency not backed by gold or anything else of value creates lots of buckets of actual dough to buy the same goods and services.
More than two-dozen bouts of hyperinflation occurred in the last century, in Germany in the 1920s, Hungary after World War II, Zimbabwe, Argentina, Chile, Brazil, Poland, Russia, and China. But hyperinflation in the U.S. is still AWOL, a spook story.
However, the Fed is not literally “printing” hard currency, the driver of price inflation. The Fed’s “money printing,” as analysts have dubbed it, doesn’t mean the central bank actually has a printing press in its cellar to mint hard currency. The U.S. Treasury runs the mint.
Instead, it’s about U.S. central bankers hitting computer buttons to conjure up $2.52 trillion in digital reserves in order to buy securities off of bank balance sheets.
Banks didn’t immediately swap these reserves into money balances, but instead placed those reserves at the U.S. central bank.
And the M2 money supply (U.S. hard currency, bank deposits and money market funds) increased a stout 43%, to $11.4 trillion, since the Fed first acted to stop the economic crisis in 2008. Still no hyperinflation.
Even more curious, the M2 money supply is now actually growing at a slower rate, 7%, than around the time the U.S. central bank conducted its third set of asset purchases in September 2012.
Also, the Fed’s zero-bound rates since December 2008 have yet to create hyperinflation. Instead, digitized money continues to pour into equity and corporate bond markets, with bubbles forming in individual stocks and junk bonds, the latter putting investors like pension funds at risk.
Ruchir Sharma, head of emerging markets at Morgan Stanley Investment Management, recently warned in the Wall Street Journal that “on average, prices for commodities from oil to coffee to eggs are up 40% since 2009, double the typical commodity-price rebound in postwar recoveries.”
But didn’t commodities prices collapse in 2008 to their lowest level in five decades, as deflation fears swept the markets? So couldn’t it be that a big jump in commodities prices since 2009 in reality is a return to normal-track growth?
Plain vanilla inflation is not here in a big way. Consumer prices, annualized, is at 2.1% as of June versus a year earlier. Inflation has been undershooting the Federal Reserve’s 2% target for more than two years, according to central bank data.
U.S. inflation “has decreased in the past two years,” says the St. Louis Fed, noting it ran at an annualized 2.29% in April 2012, dropped to 0.92% in October 2013, and then rose to 1.96% in April 2014.
However, personal consumption expenditures, at 1.7% annualized, is up from 1.3% a few months ago, and is rising towards the Fed’s 2% target more quickly than expected.
Still, despite years of geopolitical unrest, another feedstock of inflation, crude oil prices, have had their lowest price volatility in years, with Brent crude trading in its narrowest range since 2006. In fact, Brent crude is now trading at 13-month lows.
Moreover, food prices, at 15% of headline CPI “are stable in the U.S.,” notes the St. Louis Fed. Housing, which is about 41% of the CPI index, is still in recovery mode. Housing is sticky, so sticky slow is the unwind of mal-investment here.
Also, the dollar has been pretty calm of late as it remains a safe haven currency. Bank of America/Merrill Lynch notes that, since July 16, the day before Russian separatists in Ukraine allegedly shot down Malaysia Airlines flight MH17, the U.S. dollar has outpaced all major currencies.
In fact, the dollar index is little-changed from where it was just prior to when the Fed began its unprecedented stimulus in late 2008. The dollar is near an eight-month high and its volatility is about where it was in 2007.
Typically you see the velocity of money recover after a recession, but that is not happening this time. If anything, it suggests that deflation is still a much greater threat than inflation.
Mountain of Bank Reserves
The water-cooler ready fight that the $2.52 trillion in bank reserves are about to swamp the economy in hyperinflation is wrong, economists and analysts argue.
Paul Sheard, chief global economist of Standard & Poor’s, has been shouting into a field of cotton that the Fed money-printing jibe “is a misleading term,” that there is no “lurking” “runaway” inflation risk from bank reserves, and that these reserves are not just waiting to pour into the economy in terrifying amounts due to bank lending. Sheard argues that’s not how it works.
Reserves are mostly used between banks and the Federal Reserve, and don’t change the money supply. For instance, banks use their reserves to settle transactions with each other, like covering checks.
Loans are digitized, computer accounts for both banks and borrowers. Unless borrowers cash out those loans, consumer price inflation from actual currency growth won’t happen.
Here’s how it works. Say you go to the bank and get a loan. The bank gets a promissory note from you representing the loan, and electronically credits your deposit account at the bank for the loan. You then use that loan to write checks to pay off debts owed to others.
Your bank then forks over reserves to other banks to cover those checks. Sometimes, you draw down cash, so the bank does hand over hard currency. But for the most part, your loan is digitized money.
So, most of the money the Fed has conjured up remains outside the economy, parked at the Fed, and if they’re not there, reserves are moving around electronically within the banking system, from one bank’s reserve account to another bank’s reserve account. An increase in bank lending often only means a rapid movement of reserves from bank to bank. That means reserves are not yet pouring out as hard currency en masse.
Crandall explains: “An individual bank can use reserve balances to help back a loan. However, the banking system collectively cannot get rid of those reserves, as they can only be transferred to another bank.”
He adds: “Reserves are a very artificial asset and exist within a closed system. It is one variable that the Fed can control quite closely. It just happens not to be very important for the broader financial system.”
So, only the Fed can destroy reserves through open market operations, economists argue. Which is what the Fed will do if it sees hyperinflation coming, economists note, though there are risks of triggering a recession or high borrowing costs.
Economists also note that banks often do not “use” reserves as the raw material for loan-making. Crandall at Wrightson Icap explains that increasingly “banks can raise money [for loans] in so many ways,” from CDs, savings deposits, offshore deposits, “so bank reserves are simply irrelevant to their lending decisions.” He adds: “Our experience with expanded central bank balance sheets around the world in recent years has reinforced the point.”
Market guru John Hussman has also said: “Commercial, industrial and consumer loans no longer have any link to bank reserves.”
As Crandall says, “The central bank doesn’t print money in the sense of forcing it into circulation, which is the way in which physical currency usually becomes inflationary. They provide as much as the public demands, but the public can always redeposit it with banks. The bank, then, can send it back and get a credit in its reserve balance--on which it earns 0.25% [at the Fed]. Not much, but better than nothing.”
The Economy’s MRI Scan
A dashboard of economic statistics shows there’s still a lot of slack in the system, tamping down inflation pressures.
U.S. GDP growth functions as both an MRI scan on the health of the economy and of D.C. policies too, a self-inflicted wound.
Federal data show that the economy is still bed ridden compared to prior recoveries, as a ballooning federal bureaucracy continues to take money out of private sector pockets to sluice it back to the economy through its wheezing, inefficient engines.
Since the financial crash, real gross domestic product (GDP) is now lumbering along at just a 2.1% annualized rate, as a welter of anticompetitive rules and taxes continues to pour out of D.C. GDP in prior recoveries has clocked at double that rate.
Meanwhile, banks continue to buckle down on accepting only the most credit-worthy borrowers, with productivity and wages still sluggish since the 2007-2009 recession.
After peaking at 10% in October 2009, the unemployment rate has declined to 6.1% today, as labor dropouts continue to drive the rate down, keeping the labor force participation at 1978 levels while the population increases.
U.S. productivity in the first half averaged 1%, versus 0.9% in 2013 and 1.2% in 2012, shockingly low versus long-term averages of 2.5%.
“These are pathetic levels of productivity and explains why GDP growth can’t get firmly above 2.5% growth on a sustainable basis,” says Peter Boockvar, chief market analyst with the Lindsey Group. “Gains were 3.1% in 1998 and 3.5% in 1999, for perspective.”
Hourly earnings on average increased 2% versus a year earlier, still not reviving from the recession that started in December 2007 and ended in June 2009.
Where Rates Are Headed
Most of the Fed’s policy committee members have projected a median 1.5% fed funds rate by December 2015 about a year and a half from now, and a median 3% by the end of 2016, according to a recent report from Fed policymakers.
However, those rates would still be less than what the fed funds rate was in the summer of 2007, 5.25%, a year before the financial collapse. And recently the Fed repeated its mantra that rates would likely remain close to zero for a “considerable time.”
When the central bank does hike rates, it’s expected to do so in easy-to-digest quarter point increments, just as it did in the late ‘90s and early last decade.
Slow and steady, given how the bond- and stock-market capsized in the mid-90s when the Fed hiked short-term rates half a dozen times by around 2.5 percentage points within just a year’s time. The stock market then dropped 9% in a span of just three months, and the bond market had a seizure.
When it does finally hike rates, to protect itself, the Fed could continue to avoid taking losses on its own bond holdings as interest rates climb, because it is not “marking to market” its investments like private companies do—it avoided an unrealized loss of $53 billion last spring this way.
The Panic Room
The Fed does not have to sell “even a dime” of its Treasury securities to get back to “normal” monetary operations, former Fed chairman Ben Bernanke said last May: “The balance sheet could be kept where it is for a very long time if necessary.”
But if the Fed lets bank reserves sit around too long, banks can use their enormous stockpile to start lending when consumers and corporations fully heal. To stop hyperinflation, the Fed could make several moves.
To stop banks from flooding the economy with reserves, the Fed could increase the interest it pays banks to park those reserves at the central bank. Or it could raise rates, risking recession.
Or to stop inflation, the Fed could sell its Treasury holdings back to banks and brokerages to remove reserves. But all those bonds competing against each other could cause yields, and then loan costs, to rise—a bond traffic jam worsened by the European Central Bank selling about a trillion dollars’ worth of securities since 2012.
Or, the Fed could become a significant player in the reverse repo market, with interest rates that are too good to turn down, backed by sterling collateral money. The Fed could start selling off securities from its big balance sheet, agreeing to rapidly buy back those securities with interest. That way, it can move rates higher.
Still, the concern is a bond market crackup. Foreign buyers of U.S. Treasuries, notably China, sit at the top of SocGen's "black swan chart”— worrisome, since China has been scaling back purchases of long-term U.S. securities, likely due to a slowdown in its own economy.
Market watchers over at Sober Look warn: "Foreign buying of notes and bonds has declined and is not expected to replace the Fed's taper.” They add that China is likely to make short-term T- bills, versus longer-term U.S. notes and bonds, “a larger portion of its purchases,” pressuring ten-year yields higher.
Furthermore, if China’s growth were to stall and joblessness rise, China could blow out its capital accounts on an infrastructure binge, which means it would need to raise capital.
Meaning, it could sell longer-term U.S. Treasuries, which could pressure U.S. yields higher—exactly what unfolded in 2012, notes Diana Choyleva, head of macroeconomic research at Lombard Street Research.
The ten-year yield is still at record lows, hovering around 2.4%, just 0.15 percentage points away from where it was, 2.55%, when Standard & Poor's downgraded the U.S. credit rating from Triple A for the very first time in August 2011.
The fact that long rates are still at historic lows means that bond traders increasingly conclude the U.S. is in a permanent state of low interest rates, as it remains a safe haven for geopolitical crises.
Despite all that, Michala Marcussen, global head of economics at Societe Generale, expects the markets to re-price Federal Reserve action, pushing the U.S. 10-year Treasury yield up to 3.25% by year-end.
This is a confidence game, a game of expectations. The U.S. dollar retains its value because of the confidence that it can be exchanged for a certain quantity of goods or services in the future.
Undercut this confidence, cash holders then doubt the future purchasing power of the greenback and switch into hard assets. A self-reinforcing vicious cycle ensues.
The dollar has dropped 80% since 1971, 26% since 2000, as Steve Forbes notes in his new book, Money. The Fed’s powerfully large balance sheet, about twice the size of France, doesn’t inspire confidence in the U.S. dollar, either—or U.S. policy.