Painted in a Corner

ICangles Investment Post…

The Federal Reserve has painted itself into a corner, where there is no easy way out. The current global monetary system is headed for trouble. Dangers around rising inflation coupled with a weak employment environment, aka stagflation, are building. America already has the weak job market, and now as my previous post pointed out there are warning signs that the Fed’s latest policy moves are translating into inflationary forces. Having already focused on some of those signs, I am going to take a moment here to describe the dynamics of the problem. Although the leaders of the Fed not surprisingly argue there is nothing to worry about, there are three compelling reasons to believe otherwise.

Reason number one to worry is that the Federal Reserve has significantly increased the monetary base in the United States. Even though the reported money supply in the United States is anemic, as loan activity remains low, if the velocity of money were to rise and banks started loaning money more aggressively, thereby transmitting that increase in the monetary base into an increase in the money supply, inflation would surely follow. As Milton Friedman remarked, inflation is a problem of too much money chasing too few goods. Right now there is a lot of money available to be injected into the U.S. economy if banks start lending. Once that process gets underway the only thing keeping it from getting out of control is the Fed being able to slow or reverse it through intervention, with the obvious step being to quickly shrink the money base.

Courtesy of

On the surface that doesn’t sound so bad. Unfortunately, the Fed is well known for a lack of prescience instead of an abundance of foresight. Most recently it kept interest rates too low for too long allowing the residential real estate bubble to inflate, before completely failing to see the magnitude of the problem it had created and the impending disaster in the credit markets. But let’s assume the Fed bucks the trend, realizes the nature of the problem in time to act, and recognizes the need for aggressive early intervention (some economists make the case selling of Treasuries would need to be front-loaded in terms of timing). That brings us to problem number two. I’ve called the current market we are in a government debt bubble and one of the characteristics of dangerous bubbles is leverage—using credit to pile up enormous amounts of debt.

Today, the Federal Reserve has leveraged its own balance sheet to a degree not obtained by even Fannie May during the real estate bubble at about 50-1. Its balance sheet of well over $2 trillion contains less than $60 billion in capital. Quantitative easing involved the Fed growing the monetary base by basically printing money to buy toxic securities from financial firms, during the credit crisis, and then U.S. government debt in the form of Treasuries. In fact the Fed became the biggest buyer of U.S. government debt in the world. If problem one was the Fed growing the monetary base, then problem two is that all this leverage means it is very unlikely the Fed could shrink the monetary base without going broke in the process.

Courtesy of

If the Fed becomes a seller, rather than a buyer of Treasuries, in a more positive credit environment those low yielding securities will almost certainly fall in value, as those loaning money demand better terms. That means the Fed would get back less money than it paid for those securities, and be forced to realize significant losses. With that kind of leverage a move of just a few percentage points in the value of its holdings will mean the Fed booking more market losses than it has offsetting capital. The Fed simply is not going to be able to withdraw the money it has created without going broke, long before it reduced the base to the level likely needed. Of course even if the Fed could sell its holdings, there is the added problem of the Federal Reserve then competing with the Federal government, which is projected to keep selling large amounts of Treasuries, to sell to the same customers at the same time.

In an excellent interview with economist James Rickards he summarized the situation nicely stating, “They’ve got to be looking down the road and saying, gee, we say we can get inflation under control, but the tools that we have to do that will basically be raising interest rates with 10 percent unemployment, which is not going to happen, or selling bonds and going broke, which is not going to happen.” Rickards also makes some other excellent points, including the motivation for the Fed in pursuing a policy that seems at odds with common sense, but I am going to take the opportunity here to expand on the problems around raising rates in the current environment.

Ideally of course the Fed could simply stave off inflation by rising interest rates, reducing the velocity of money and tapping down on the conversion of liquidity from a static monetary base into a dynamic money supply that is active in the economy. That way it would sidestep problem number two of leverage. But that brings us to problem number three. As documented in my last post signs of inflation are already appearing with correlations arising between the Fed’s quantitative easing and rising commodity prices. In other words there are already signs of inflation, despite very high unemployment that if accurately measured is closer to twenty than ten percent (see my post Reading the Unemployment Tea Leaves).

Courtesy of Gallup

Examining the dynamics of problem number three, requires a close look at currency policies—largely but not exclusively that of China and America. The so-called Chimerica relationship is currently exporting inflation from America into China and from there out to the rest of the world. Here is how the process works. China manages its currency, keeping it artificially low versus the U.S. dollar, in order to keep its exports cheap and sell more products in America. When it sells goods in America it earns U.S. dollars. But unlike a country such as Germany, which uses a currency that for the most part floats, China intervenes to manage the value of its currency and keep it low. It buys back the earned dollars from exporting firms. In return for those dollars it prints its own currency, growing its own money supply, and gives that to the exporters. China then has used many of the acquired dollars to buy Treasuries and become one of the biggest holders of U.S. government debt in the process.

Dollars earned by exporters equals money China must create, and to keep its currency artificially low it must create more money than is prudent from a price stability standpoint. The net result is an expansionary bias in Chinese monetary policy regardless of the inflation risk. And unlike present day America, China has a high velocity of money. Despite that government’s best efforts to clamp down on lending, money is making its way into the economy. In addition because many investors expect that exporting countries, like China, must eventually allow their currencies to appreciate so-called ‘hot money’ from the developed world is directed into those economies, as investors consider such investments likely to appreciate from a currency perspective, even if the underlying investment makes nothing in local currency terms.

What is more, Chinese disinflationary forces that have hereto helped counteract inflationary forces are dissipating. Wage pressures have been building in China, as the slack has been taken out of the available workforce. The result of all of this is real, not theoretical, inflation. Prices are being pushed up for items in China and global commodities in general. But while nobody disputes there are real inflation problems in China, many dismiss concerns over inflation impacting the United States. They frequently point to the earlier mentioned money supply figures. But as Mark Twain famously quipped, “there are lies, damn lies and statistics.” And there is good reason to question those figures.

China doesn’t fully and accurately report the size of its U.S. dollar holdings or what it is doing with them. But we do know one thing it is not doing with them any longer. China is not investing its dollars into copious amounts of Treasuries, because the Fed with its quantitative easing policy has been buying about 70 percent of U.S. government debt recently. It’s simple math that doesn’t show up in money supply charts, but China by necessity must direct the U.S. dollars it earns in exports and maturing Treasuries into other dollar denominated investments. Every dollar of Treasuries the Fed buys by printing a dollar, pushes Chinese money, or that of other exporting nations managing their currencies, into something else, such as commodities.

This dynamic must by its very nature be expansionary for the global money supply of U.S. dollars.  If you are looking for a primary causation of the tight correlation between quantitative easing by the Fed and rising commodity prices, despite statistics not showing an increase in the money supply, it can be found in such intuitively necessary, but opaque, Chinese actions. The dollar is weakening as a currency and commodities are rising, because even though U.S. banks aren’t actively lending, the supply of U.S. dollars in the global economy is growing. The Fed and the official money supply charts focused on the American financial system may argue otherwise. But, the question is who are you going to believe—the government and official statistics or the currency and commodity markets along with basic reasoning?

Source: RJO Market Research & Trading

Focusing on China, it has painted itself into a similar corner as the Fed. It can use some of its dollars to buy commodities and use some of its money for subsidies to offset the price rises, but only to a limited degree before that becomes a problem for its exporters. With such immense holdings of Treasuries it can’t sell them in mass anymore than the Fed can sell its own holdings, without moving the value down and deteriorating its balance sheet in the process. Nor can China simply allow its currency to float and appreciate quickly without damaging its critically important export sector. Therefore, China will be forced to continue relying on its willing co-conspirator, the American government, which is happy to sell China its debt to subsidize budget deficits via the only existing market in the world with the requisite levels of liquidity for such huge, recurring transactions, the U.S. Treasury market.

Aware of the risks China’s government is trying to manage a gradual appreciation, move its economy over time from its export dependence and slowly diversify away from Treasuries, although there is no real alternative currency market currently in existence to absorb over the long-term trade surpluses in such amounts. Inflation pressures however, are rising faster in China and other exporting nations, than such gradual policies are able to offset. And the American government, which runs huge fiscal deficits, needs China to keep cheaply loaning those dollars it earns by purchasing Treasury securities, since the Fed can’t just go on printing money to buy the U.S. government’s debt. So, prospects for a sudden, substantial currency revaluation that would end the transmission of inflation from America to China are slim at best, as the interest of politicians in both countries argues against forcing the issue.

The net result is to expect inflation to keep gaining momentum, as those in power play down the threat and do nothing, because at this point there is very little they can do. The Fed isn’t going to aggressively lower the monetary base and go broke in the process. It also isn’t going to rise rates to get ahead of inflation, which might or might not be a threat, when the employment environment is demonstrably weak. The Chinese are not going to suddenly float their currency, and risk the instability around potential mass unemployment in their exporting sector. There will be no forceful actions to stop the problem before it drives a downturn, anymore than there was action ahead of time to stop the other excess liquidity events of the recent past from the Asian credit crisis to the dotcom bubble or the real estate bubble.

The difference this time is that with the Fed leveraged out and consumer prices rising, we will not be able to turn on the liquidity spigots again to drive some false growth around a new bubble and power out of the downturn. Like a heroine junky we’ve reached the point where we need a fix simply to get by with the Fed funds rate approaching zero just to support an anemic recovery. Taking much more liquidity would kill the economy, but at least the Fed is extremely unlikely to administer any hyperinflationary overdose. Although those at the Fed may not be as smart as they think they are and history keeps proving, they are smart enough to not keep trying to print their way out of trouble when inflation does become an undeniable problem.

Yet this will certainly be the end of the cheap money era. A revisit to the 1981-82 recession with rising unemployment and interest rates will be a distinct possibility. But with monetary policy currently more extreme than anything in the recent past, inflationary pressure could surprise by being stronger than most expect. In such a bind seemingly fantastical calls for a return to hard money will suddenly become credible, especially given the impact of rising debt maintenance costs if rates rise significantly on indebted federal, state and local governments. There will be no easy way out of this predicament. Covering over economic problems by applying liquidity only works for so long before the liquidity itself becomes the problem. Such is the nature of the corner the Fed has painted itself into.

UPDATE on May 24, 2011 the Wall Street Journal posted the editorial “The Return of Stagflation” detailing how the Fed is exporting inflation in the current global monetary system.


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