Inflation, Deflation, or Bust

At 7:15 p.m. London time came the news we already knew: the Fed raised rates an 18th time – to 5.25%. Inflation will be tamed! Deflation, be damned!

Concerning the U.S. economy, and by implication the entire world, there are two major currents of thought. There are, on the one hand, those who believe in the perfection of man and those who don’t. The first group thinks the science of central banking has made amazing strides. In the 1980s, the Volcker Fed learned that it could tame inflation. Then, 20 years later, the Greenspan Fed found that it could avoid deflation, too.

Central bankers now have at their command whole armies of statisticians, number crunchers, and economists. When their forward listening posts hear the sounds of oncoming inflation, for example, the feds set the range on their heavy artillery and begin firing away. On the other hand, if it is deflation on the march they know what to do – blow up the dikes! Open the sluices and floodgates! Flood the paddies and lowlands with liquidity!

In the view of the first group, the Fed has finally got the hang of it, and the latest GDP figure, 5.6% growth in the first quarter, proves it. The experts have become so good at fighting both inflation and deflation that neither poses any further real danger. The U.S. economy is impregnable, a citadel of growth that will continue expanding forever and ever, amen.

Nay, say the naysayers; it doesn’t work that way. An increase in firepower doesn’t eliminate war; it just makes it more costly. At the heart of the Fed is a heart…a living, heaving, squeezing, juice-pumping human heart. And like all human hearts, it is sometimes good, some times bad, but always subject to influence. And the influence to which a central bankers heart is subject is not one easily brushed aside. What can a man do but bend a little when the president of the United States of America leans on him? And when his cronies and future employers on Wall Street come into the bar and ask for more liquidity, can he really say no?

A poll, released just yesterday, tells us that Americans now oppose more rate increases by a margin of three to one. What is more amazing is that they have any opinion at all. The going rate of short-term credit is hardly a matter for public debate. It is, or should be, what it is: a natural equilibrium worked out between borrowers and lenders themselves. Instead, voters expect to find it on the next ballot, along with grumpy resolutions proposing to skip winter this year and round off pi to the nearest whole number.

‘Liquidity’ is an economist’s word for more cash and credit. ‘Inflation’ is the word used to describe what happens to a currency when too much liquidity is made available. Central banks can control the quantity of the money they emit, and by extension, its quality. What they cannot do is increase the quantity and the quality at the same time. Given a hard choice, they almost always give way to quantity and let the quality go to hell. The supply of currency increases; it is “inflated.” Sooner or later, inflation of the money supply leads to the kind of inflation that voters recognize, an increase in consumer prices.

This second group, more skeptical than the first, and long gold, believes the Fed is neither as competent nor as determined to fight inflation as it pretends. It expects neither sorrow on the part of the Fed for all the inflation it has wrought, nor pity on all the poor householders who live on fixed budgets and low savings. The Fed may want to fight inflation, they say, but its hands are tied. The federal checkbook is overdrawn by some $500 billion this year. In addition, the U.S. Treasury has a trillion-dollar mountain of short-term debt it must refinance in the months ahead. And then, there are the voters themselves, faced with rising interest rates, falling house values and $2.7 trillion worth of adjustable rate mortgages that will be reset in the next 24 months. It’s no wonder they want lower rates. Under these conditions, consumer price inflation should increase steadily, and the price of gold should climb.

Today’s little reflection suggests that both groups – optimists and pessimists – are wrong. We begin and end by pointing out the obvious. The world may have too many dollars, but it also has too few. Central bankers’ vaults, drug runners’ pockets, and Wal-Mart’s cash registers may be full of them, but there is another side of the ledger, too. Average Americans already are having trouble finding enough dollars to pay their bills. When the going gets tough, they may have even more trouble finding that elusive dollar.

According to the latest report from Charles Gave and Anatole Kaletsky, consumers did not cut spending in order to balance their household books. That is why spending has been so robust. It is up at a 5.1% annual rate in the first quarter. Cutting back expenses and saving money may have been the prudent thing to do, but it would not have been as much fun. And why bother? You save for a rainy day. But if the Fed is really as good as it thinks it is, you can throw away the umbrellas.

Instead of cutting back, they borrowed more – in dollars. These extra borrowings create what could be viewed as a massive short position in the U.S. currency. People must need more dollars than ever before, in order to service past loans as well as maintain their current living standards. Gave/Kal write:

“The bottom line is that oil consumers around the world have decided to postpone as much as they could the moment of reckoning which the increase in oil prices should have triggered. They have decided to borrow dollars (or yens?) to buy oil. As a result, a number of countries are now not only short oil, but are increasingly short the dollar. This means that, slowly but surely, we are building a corner on the U.S. dollar similar to the one we built in the period from 1978 to 1980, or from 1995-97…”

Their conclusion: buy assets with cash flow denominated in U.S. dollars.

Consumers edged themselves into more debt rather than face up to declining spending power. Now they’re in worse shape than ever. They have no room to maneuver. Unlike the Japanese, they cannot hunker down and wait out a recession; they have bills to pay! So has the Fed edged itself into a tight spot of its own. Armed to the teeth to fight inflation or deflation, it cannot fire a shot.

Over the horizon are the forces of inflation. Bernanke trains his guns on a 2% core rate as if he were Patton aiming at Metz. That there is no real enemy in front of him, no one bothers to mention. If inflation were a problem, speculators haven’t noticed – they recently sold off commodities to buy the dollar! Nor is inflation given any support from wages; for most people, wages are going nowhere. Even gold, that ancient hedge against inflation, acts as if there were nothing to worry about; it rises no faster than base metal.

But what would the Fed do if inflation really were attacking? In the late ’70s, Paul Volcker had to set the price of credit at 15% in order to bring stop inflation’s advance, causing the worst recession since the 1930s. Members of Congress called for his resignation. Members of the public burned him in effigy. And that was before the country went on its borrowing binge. A 15% fed funds rate today is not impossible, but it would bankrupt 10 million people, and Ben Bernanke would have to flee for his life.

That is why real consumer price inflation, when it comes, will get little fight from the Fed.

While the Fed engages in mock battle with inflation, its real enemy takes the field hardly noticed. Here is where we part company with economists, kibitzers, and commentators on both sides of the argument. The naysayers argue that the Fed’s inability to fight inflation guarantees a higher gold price. As Dan Denning puts it, “The fed has one way and one way only of coping with high consumer and government debt levels: it has to inflate.” That may be, but it is not the fight against inflation that is likely to be lost first. When push comes to shove, the Fed will fall over. Just as it is unable to fight inflation, it is unable to fight deflation, too. It has spiked its own guns.

Welcome to cruel irony. Welcome to sweet revenge. Welcome to Tokyo!

The risk of consumer price inflation is more consumer price inflation. People see the value of their currency dropping and rush to get rid of it. Prices rise even more. In the most spectacular case in modern history, in Weimar Germany, inflation got to such levels that employees insisted on being paid twice a day, and a man mailed his landlord his rent in the morning. By the time the letter arrived in the next day, the rent money was worth less than the stamp on the envelope.

But it is not consumer price inflation that the U.S. economy most has to fear, it is inflation in a more agreeable form: asset price inflation. Houses, in particular, have gone up. And the risk from this kind of inflation is different; the risk is not more inflation, it is less inflation – or deflation. House prices have already begun to go down. Meanwhile, high energy costs are draining cash away from American consumers and toward strange and unfriendly places: Russia, Venezuela, and Saudi Arabia. The price of gasoline averaged $2.34 per gallon in the first quarter of this year. Now, it is $2.84. The demand for dollars is increasing, even as their intrinsic value goes down. But Bernanke still believes he is fighting the first kind of inflation, not the second. He trains his cannon on consumer price inflation, and makes noise. Kapow! Kaboom!

But out on the vast plain of Middle America, the flowers begin to wilt. Where will the money come from to pay the mortgage? How will the tank be filled? And by the time Ben Bernanke has his helicopters gassed up and loaded with twenties, it may be too late. The nation may already be in deflation’s grip – like Japan in the ’90s or America in the ’30s – with declining property prices squeezing the juice out of consumer spending. If prices for houses fall, who will borrow to buy another one? How can the feds push their debt when the nation finally goes on the wagon? Why will people spend now, when they can get a better deal next month? Won’t they finally get out their umbrellas when they see the clouds forming overhead?

A pullback by American consumers, caused by declining house prices, would put the whole world into the dryer. Liquidity would disappear. Even the hint of declining liquidity, given out a few weeks ago by central bankers themselves, caused cracked lips and parched throats. Commodities fell 20% or more. Gold lost $100. Emerging markets shook and quavered. Imagine what a real deflation would do! When the debt-soaked U.S. householder dries out, the whole world goes into a slump. Chinese factories would go quiet. The demand for raw materials would collapse. Unemployment would increase. Wage progress, feeble as it is, would go negative. Even the debt pushers would have to look for other work. Refinancings could turn brown and curl up like an old leaf. Defaults and bankruptcies would soar. Gold, the ultimate safe haven, may be the only thing to go up. As for the dollar, it might fall in the currency markets, but still be in demand at home. Instead of finding themselves with too many dollars, Americans would find they had not enough.

Bill Bonner
The Daily Reckoning