EC Inflation Is A Monetary Curse

The Fed overseas two separate mechanisms for currency expansion. Quantitative easing is targeted at providing investing institutions with cash in return for low-risk assets, specifically US Treasury and agency bonds to the tune of $120bn every month. This QE has the effect of keeping bond yields suppressed and equity markets inflated because of the targeted institutions’ reinvestments. In addition — and it is separate from QE — there is the government’s budget deficit, theoretically financed out of private sector savings, but in the absence of an increase in the savings ratio, financed through the expansion of currency and credit.

Fund raising for the government is about to become chaotic

We can see that the Fed’s non-monetary approach to monetary policy begs important questions, but there are usually reasons behind it which we must consider. They give us a steer to the Fed’s real mission; its twin objectives of 2% price inflation and full employment having become secondary. It is to keep the Federal government financed by suppressing the interest cost and encouraging the expansion of bank credit to subscribe for government debt. The latter task was made easier during covid lockdowns, since unspent income temporarily accumulated in the financial system, which together with currency and credit expansion led to the government being awash with funds. But that has now changed, as the balance on the government’s general account at the Fed in Figure 2 shows.

Since March 2020, when the balance was $380bn, the government accumulated a further $1.437 trillion to a balance of $1.817 trillion in a little over four months, funded by a mixture of currency and credit inflation to fund extra government debt. Since August last year, all that accumulation and a little more has been spent into general circulation, leading to liquidity flooding the economy. This liquidity has been absorbed by the Fed’s reverse repo (RRP) balances expanding to over a trillion dollars. The increase in RRPs had been necessary to prevent bank deposit and money market rates from going negative due to excessive liquidity.

The effect on the dollar of the RRP level increasing has been to stabilise it on the foreign exchanges and to pause the headlong increase in commodity and raw material prices for the last few months. But this will almost certainly turn out to be a temporary effect. Assuming the debt ceiling will be raised in the coming weeks (it is inconceivable that either it will not or it will be suspended) the US Government will resume selling US Treasuries and T-bills into the market to top up its general account and fund its ongoing deficit. No doubt, the plan initially is for the Fed to accommodate this demand by reducing its outstanding RRP balances, thereby keeping its funds rate at the zero bound, and therefore yields on US Treasury stock suppressed.

The best laid plans need numbers to add up, and immediately we can see a problem. The Fed may have a trillion up its sleeve in the form of RRPs which can be wound down. But the Biden administration is planning $6 trillion spending in fiscal 2022, rising to $8.2 trillion by 2031. Combined with a structural deficit, the government deficit next year will almost certainly be substantially higher than the Congressional Budget Office’s current forecasts. Furthermore, the CBO assumes the annual average growth of “real” GDP will average 2.8% during fiscal 2021—2025, an assumption that is looking optimistic, given the unexpected increase in the price deflator.

In recent years the CBO’s forecasts have turned out to be overly optimistic. Furthermore, disruption of global logistics is an ongoing problem, so the supply of products to satisfy the increase in consumer spending assumed in the forecasts will continue to be restricted well into 2022. Covid disruptions have not ended and increases in infections are likely in the coming months. It all adds up to a recovery in tax revenues being postponed again, and government spending being increased more than budgeted, even before taking Biden’s proposed extra spending into account.

The CBO’s optimistic assessment of the government deficit for next year is $1.153 trillion, reducing from over $3 trillion in the current year. Allowing for all the factors listed above, more realistically, another $3 trillion deficit is likely to be the minimum for fiscal 2022, which commences at the end of this month.

Therefore, the simple problem is one of the Fed only being able to release one trillion of RRP liquidity into a market that will face demands for three trillion or more, being the likely fiscal deficit for 2022. We are back to where we were in March 2020, when the CBO forecast the deficit at $1.073 trillion, but the outturn was $3.13 trillion.

The problem for the US Treasury is it cannot close the fiscal gap, even if it wanted to — which it doesn’t. Putting record budget deficits to one side, the neo-Keynesian script demands yet more stimulus. But consumer prices are rising and are continuing to do so as the economy falters. Raising the general level of taxation would obviously be counterproductive and cutting government spending is politically impossible — not least because spending $6 trillion is Biden’s committed plan. No wonder he is looking for ways to tax the rich to fund his planned spending, but even his economic advisers must realise the numbers simply don’t stack up.

With the Biden administration unable to reduce its budget deficit, a rising interest rate environment, reflecting price inflation, is bound to result in a funding crisis. These are the debt trap circumstances which not only deters foreign ownership of the currency but persuades foreigners to dump existing currency holdings in increasing amounts. It is the downside of the Triffin dilemma, when decades of irresponsible fiscal policy are encouraged to supply foreigners with a reserve currency. Inevitably, it ends with a currency crisis. It is what led to the gold pool failure in the late 1960s and ended the Bretton Woods agreement in 1971. And according to the Treasury’s own TIC figures, foreign investment in dollar-denominated financial assets and cash now exceeds $32 trillion, roughly 150% of US GDP. The dollar has never been so over-owned by flaky foreign interests.

The impact on the dollar

While Powell hinted in his speech that tapering QE at some point is on the cards, it will simply not be possible if a similar budget deficit to this year is to be funded in 2022. Furthermore, in real terms interest rates are now deeply negative.

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Disclaimer: The views and opinions expressed in this article are those of the author(s) and do not reflect those of Goldmoney, unless expressly stated. The article is for general information ...

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