When will inflation kick in?

Reading time: 9 – 14 minutes

The lack of fiscal restraint of President Obama on the healthcare issue, the ’stimulus bill’, and other ‘progressive’ legislation in the pipeline, combined with the jobs-firsts-inflation-last attitude of Fed Chairman Bernanke — leave little room to doubt that sooner or later the United States is likely to enter the realm of double-digit inflation.

The question is when and how sudden will be the transition?

Or will the opposition be able to turn the rascals out and repeal bad laws, in time to save the nation from disaster?

It is impossible to say when inflation will start because the political environment is uncertain and conflicted.

Investors who are holding long bonds when inflation hits will suffer severe losses. However, to hold on to almost-zero-interest short bonds is to give up income.

If inflation hits suddenly, there may not be time to repurpose one’s portfolio.

The losses to long bond holders due to a sudden rise in interest rates could be as severe as losses to those holding securities in the Crash of 2008.

Inflation is likely be the final and deadliest blow to the retirement dreams of many Baby Boomers. When the stock market crashes, one can hope for a recovery some day.

With inflation, the losses are permanent and final.

Can Bernanke stop inflation?

There are only three ways to avoid the inflation that is being ginned up by the extraordinary spending of the Obama administration (other than the obvious: fire government employees, repeal Obama spending measures, and reduce government outlays — all highly unlikely in a world of political ninnies and economic fools).

Here are the options:

Poor Ben Bernanke, driven by ambition and lost in dreams of the Great Depression.

1. Increase taxes, thereby reducing or eliminating the deficit. However, increasing taxes tends to increase unemployment.
2. Sell government bonds to raise funds to cover the deficit. However, this incurs interest costs and places the burden of deficit spending on future generations. Furthermore, if the deficit is large enough, there might not be enough buyers to take up an issue.
3. Increase mandatory reserve requirements for bank deposits. Fed Chairman Bernanke has already said that he doesn’t want to do this. Furthermore, money market funds now have largely taken the place of traditional bank checking deposits, and money market funds do not have reserve requirements.

A combination of these three methods may be used.

A deficit of political capital

However, to be successful, the President and the Fed Chairman must be willing to expend political capital, adopting three highly unpopular positions:

Obama has cast a spell over the masses for just long enough to lead the country into the economic brambles

1. Allow unemployment to increase;
2. Restrict credit and financial sector profits;
3. Increase taxes and reduce government spending.

After the unpopular Obamacare legislation, the administration is plumb out of political capital to spend.

Furthermore, a large portion of the population doesn’t understand the threat of inflation.  After all, it has been thirty years since Jimmy Carter was in office. Only people sixty or older are likely to have had the responsibility of raising a family in Carter’s stagflation — and that was mild compared to the level of spending Obama has demanded.

Most of the population either have more debt than assets and will benefit from inflation (at first), or haven’t lived long enough to have a visceral understanding of the threat.

No, it seems likely that inflation will have to hit first, and hard, and a conservative administration (in the mold of Reagan) with new political capital, will have to be elected, before the United States will seriously address inflation. Bernanke will have to be fired and someone in the mold of Paul Volcker will have to chair the Fed.

In other words, we’re not  even near being there yet.

Taxes and unemployment

With unemployment hovering around 10% and underemployment even higher, raising taxes would be counterproductive, not only to economic recovery but to the continuation of the Democratic Party in power.

Nevertheless, the Obama administration, in a rush to jam through radical socialist legislation, has had to resort to tax increases — but only to a degree that ensures continued high unemployment, without overcoming the threat of impending inflation.

Millions unemployed will be the victims of Obama's folly.

The Obamacare legislation, alone, is likely to increase unemployment as businesses, large and small, are hit with higher costs and refrain from hiring.

Many already believe that Obama policies have contributed to unemployment,

The ’stimulus’ legislation of early 2009, did not reduce unemployment as promised. Deficit spending that is already in the pipeline will keep taxes high — and will encourage even higher taxes.

The only boom in employment under Obama is likely to be in the public sector or in businesses selling goods and services to the government — not a attractive basis for economic progress — except, perhaps, to a committed Marxist.

Chairman Bernanke, has no power over taxation — a Congressional prerogative — but he seems to fear increases in unemployment more than inflation and is trying to inflate the economic in the wistful hope that inflation will somehow produce employment.

Jimmy Carter found that this is not true.

Foreign buyers of Treasury bonds

Even since the Nixon administration, the US trade deficit has been increasing, creating an ever growing volume of dollar financial assets in the hands of the rest of the world.

The net dollar financial holdings (assets less liabilities) of foreign investors was $7.7 trillion in 2007 and rose to $7.9 trillion in 2009.  A large portion of these assets are owned by Chinese interests.

This increase in the trade deficit of only about $200 billion falls far short of the trillion dollar deficits being produced by the Obama administration.

The Chinese may have better things to do than invest in Obama's bonds.

The costs of the War on Terror during the Bush years were largely financed by dollars that had accumulated in the hands of foreigners over the years as the result of the trade deficit.

However, the Crash of 2008 combined with the insane spending of the Obama administration, have created the expectation of deficits so large that there is no hope of covering the shortfall with dollars from the trade deficit.

Furthermore, Obama, with a profound and willful misunderstanding of economics, seems bent on bowing to perennial trade union pressure and to accept protectionist measures.

The American people, meanwhile, are saving like mad, fearful of grim days to come — reducing consumption along with the demand for foreign goods.  This suggests that the trade deficit will not expand fast enough to fund the extreme federal deficits being ginned up by Obama, Reid, and Pelosi.

As the trade deficit levels off, foreign holders of dollar financial assets are likely to seek safe haven against the coming inflation by going into US real estate or other assets.

The American industrial base has been so eroded over the years by over-regulation and the demands of trade unions that even a fall in the dollar is unlikely to boost exports and improve employment significantly.

Domestic buyers of Treasury bonds

At some level of deficit spending, the amount of Treasury bonds that would need to be sold to soak up the money being ‘printed’ by the government, exceeds the combined demand for such bonds on the part of foreign and domestic investors.  At some point, interest rates soar, along with prices of goods and services and people will face the full force of inflation.

Now, government issues of Treasury bonds compete with financing of private business and consumer spending.

So, the bigger the deficit ‘hole’, the more restraints bond issues would have on business expansion, restricting job opportunities and boosting interest rates. In the extreme, long term debt becomes worthless.

An indicator of changing demand for short term debt can be seen from the portfolio composition of money market funds, before and after the Crash of 2008 (year 2007 compared to year 2009), as shown in the following graph:

Government debt, because of a higher credit rating, easily forces out private borrowing, as shown in this chart. Source: Federal Reserve Flow of Funds Accounts Q4 2009.

The graph shows how money market funds switched from private debt to government guaranteed debt after the collapse of 2008, moving into time and savings deposits, municipal securities, agency bonds, and Treasury bonds.

However, the total amount of funds employed did not change significantly, even though household savings increased.

To sell Treasuries, buyers must have cash

When the government tries to sell Treasuries to sop up ‘excess cash’ that was injected into the economic system by trillion dollar deficit spending, there must be people with this ‘excess cash’ interested in acquiring such securities.

One of the things one learns from flow of funds accounts is that, on close inspection, this ‘excess cash’ in such large amounts is already applied for some purpose.

Even for the Super-Rich in mansions like this, a trillion dollars is a lot of money.

Basically, the government would be asking people to sell some other financial assets in order to buy government bonds. Generally this would mean reducing financing for private businesses or consumer spending.

As shown in the article, “Why are the Super-Rich often liberals?”, about 32% of total household assets are held by the top 1% of the population.

These Super-Rich hold about $20 trillion in financial assets. However, these people already have all the Treasury bonds they want and wouldn’t be happy being forced to sell assets in the private sector, such as, say, a controlling interest in a corporation, in order to buy government bonds.

Furthermore, the $20 trillion dollars of financial assets held by the Super-Rich, although this seems to be a huge amount compared to the wealth of the rest of the population, is not so large when compared to the multi-trillion dollar deficits being created by the Obama administration.

It’s easier to inflate than deflate

It should be clear that the demand for Treasury securities is not unlimited and that a consequence of extreme deficit spending is the tightening of credit in the private sector, ramping up inflation and unemployment.

What do you think?

Do you know when will inflation hit?  2010? 2011? 2014? I don’t.  Government budgets are far from transparent and full of hidden surprises and traps.

But I do know that extreme deficit spending brings on problems beyond the simple transfer of debt to grandchildren.

In fact, wild economic behavior is more likely to bring on runaway inflation and pain to the current generation — wiping out the assets of the living, and also the debt our grandchildren might have to pay.