EC Inflation Is A Monetary Curse

The impact on the dollar of another expansion of monetary policy on top of deeply negative real rates is likely to follow the pattern established in March last year. The Fed cut interest rates by 1.75% in two steps to the zero bound and announced monthly QE of $120bn. Foreigners at that time turned out to be particularly sensitive to these developments, driving the trade-weighted index down 13% between the Fed’s reflation announcements in March 2020 and January this year. More importantly, commodity and raw material prices moved significantly higher, or put more accurately the dollar lost substantial purchasing power in commodity markets. The gold price moved from a low of $1450 to a high last August of $2075.

But price inflation today is far higher than in March 2020, equivalent to a cut in interest rates into deeply negative territory in real terms — considerably greater than the 1.75% cut eighteen months ago. And the increasing certainty of rising interest rates and the effect on financial asset values rules out tapering — if anything, it is likely to be increased at the first sign of markets stumbling.

In March 2020, official price inflation measured by the CPI (U) was 1.5%. In July 2021, it was 5.4%, the equivalent of a cut in real interest rates of 4%. When they become more sensitive to the deficit arithmetic, the question now arises as to how foreigners will value the dollar against other currencies, and more importantly, against commodities. The dollar’s dead-cat bounce and the recent sideways consolidation in commodities and raw materials will not only be over, but the higher starting point for price inflation is likely to make their reactions more severe. The effect on US domestic prices are bound to reflect these factors, with price inflation increasing substantially from current levels.

We can see that in theory the first trillion of the government’s budget deficit should not be too much of a funding problem, because the Fed has a trillion of RRPs to release, which in roundabout ways can be deployed into US Treasuries. But funding the likely higher deficit at current coupons will almost certainly turn into an impossibility. Not only are implied rates highly negative in real terms, but with price inflation rising even more, coupons will have to rise significantly. The possibility that Shadowstats might record true price inflation at over 20% becomes a live prospect.

Unless the American public increase their savings materially — which is highly unlikely and therefore can be ruled out — the budget deficit will be broadly mirrored in a continuing trade deficit. So not only will foreigners be dumping over-owned dollars, but they will have further dollars to sell as well.

Rising bond yields drives bear markets

With an increasing inevitability, yields on US Treasuries are bound to rise considerably from deeply negative real rates. And since equity markets take their cue from bond yields, the damage to values in those and all other financial assets will be substantial. The more so, because the Fed has pursued a policy of inflating values of all financial assets through unprecedented levels of QE. The mystery is why markets view talk of reducing QE with equanimity.

Experience informs us that market participants can be complacent for long periods, and that during such times, the monetary authorities can suppress interest rates and distort markets with impunity. We have been in such a period for decades. The American investing public is now fully predisposed to be unquestionably bullish of financial assets having not known a period when markets, and not the Fed, decided values. Like the Fed, investors only accept the inevitable consequences of currency inflation reluctantly.

When triggered by events, the discovery of true economic and financial conditions leads to market moves that can be violent, taking nearly everyone by surprise. The consequences are likely to become self-feeding, with rising bond yields imposed by markets on the Fed, rather than the other way round, making debt funding problems even worse.

The Fed doesn’t have a mandate to just stand back and let markets decide outcomes, which is what it should do and is going to happen eventually anyway. But rising interest rates create enormous problems not just for relative values in financial assets generally, but threatens to wipe out overly indebted borrowers, including over-leveraged businesses, corporate zombies and others burdened with unproductive debt. They will also undermine commercial and residential property markets. Even the solvency of the government becomes questioned. The days when a Paul Volcker can simply raise the Fed’s fund rate to whatever it takes to kickstart falling interest rates are clearly over.

The combination of Biden’s spending proposals and a stagnating economy is making it impossible for the Fed to continue to suppress interest rates and therefore bond yields. And it is equally impossible to see how the Fed can stop them from rising without sacrificing the dollar. Not only are we going to see a new trend of rising yields established, but very quickly it will be evident there is no visible end to it. These were the dynamics faced by Rudolf von Havenstein when he was President of the Reichsbank during Germany’s hyperinflation of 1921—1923. And we know what happened at that time. And as Jay Powell demonstrated at Jackson Hole, the importance he attributes to the consequences of monetary expansion mirrors that of von Havenstein.

The truth of an emerging situation is that America has changed from a low inflation economy with a gentle erosion of the dollar’s value artificially cheapening US Treasury debt, to a commitment to hyperinflation, the start of which was the rapid expansion of M1 money supply as shown in Figure 1 above.

Meanwhile, equity markets have become wildly overvalued on the back of the Fed’s guarantee that they will never fall; that is the primary purpose of QE. A falling dollar and rising bond yields along the curve will almost certainly be the signal for the start of a bear market. And with foreign investors holding $13.3 trillion in US equities as of end-June (up $4.1 trillion in a year) foreign selling of both equities and the dollar proceeds could well be an early feature of a new bear market.

If the Fed loses control over rates, the bear market will be considerable. But the Fed is expected to keep economic confidence high. If it is to save markets, it will have to increase QE at the start of any significant fall in the S&P 500 Index — standing back and watching investors being hammered is not an option. This is why QE was reinstated in March 2020 and continues to this day at $120bn every month, amounting to $2 trillion so far.

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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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