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  • Giorgio Tavazza

Why inflation will be much higher in the 2020s: The biggest Fed policy mistake.


"The reason inflation was brought down to manageable levels, by the time of Ronald Reagan's re-election, was directly attributable to Jimmy Carter's very courageous act, hiring a Federal Reserve chair, with the charge to induce a recession. That recession was probably the reason he didn't win a second term."

-Rick Perlstein



Why are governments around the world not acting to stop inflation?


The dangers of inflation to the peace and prosperity of a nation are clear. Why, then, are governments worldwide not doing much to fight it?


The Federal Reserve (Fed) and the European Central Bank (ECB) have kept interests rates at 0% and increased their balance sheets during 2020 and 2021. These measures are highly inflationary as they increase the money supply in economies with low productivity rates.


As we have seen before, the recipe for higher inflation is money printing accompanied by lower productivity, creating higher demand with a lower supply of goods and services.


The question then should be, why are central banks following the recipe for higher inflation so deliberately?


Because they can't do the opposite, they are trapped. Fighting inflation with the proper measures would mean complete chaos and possible governments' default.


Fighting inflation would mean creating a big problem now to avoid a bigger problem in the future. And the sad reality is that politicians only care about being re-elected. Therefore they want to kick the can down the road as much as possible, to make it somebody else's problem.



What is the cure to high inflation?


"Five simple truths embody most of what we know about inflation: Inflation is a monetary phenomenon arising from a more rapid increase in the quantity of money than in output (though, of course, the reasons for the increase in money may be various). In today's world government determines—or can determine—the quantity of money. There is only one cure for inflation: a slower rate of increase in the quantity of money. It takes time—measured in years, not months—for inflation to develop; it takes time for inflation to be cured. Unpleasant side effects of the cure are unavoidable."

- Milton Friedman



We have seen that increasing the money supply increases inflation. Central bankers increase the money supply to stimulate the economy and avoid possible recessions. This process is done through what is called Quantitative Easing (QE).

QE is an unconventional monetary policy in which a Central Bank purchases long-term securities like Treasuries or Mortgage-Backed Securities (MBS) through the open market. This buying activity adds liquidity to the market and creates a distorted demand for long-term securities. By creating this artificial demand, Central Banks are able to keep interest rates for treasuries and MBS to lower levels.


Another critical tool central banks use to stimulate the economy is the Fed fund rate. The Fed Fund Rate is the target interest rate set by the Federal Open Market Committee (FOMC). This target is the rate at which commercial banks borrow and lend their excess reserves to each other overnight. The Fed fund rate significantly impacts the economy as higher rates mean higher borrowing costs for everybody.


With low interest rates, people can afford to borrow more, increasing liquidity in the market. To understand the importance of interest rates in the economy, we can look at the relationship between interest rates and housing prices.


Most people buy homes with mortgages. They calculate how much they could pay monthly for a mortgage based on their income. If a family earns $10,000/month, it may decide that it can afford a monthly mortgage payment of $3,000.


With a low interest rate of 3% and a 30 year fixed mortgage, the family can borrow $600,000. If instead of 3%, the interest rate was 7%, the family would only afford to borrow $400,000. Having a lower budget, the demand for $600,000 homes would decrease, bringing down prices.

With higher interest rates, liquidity in the market decreases, which lowers prices.


It's important to understand that higher interest rates don't affect only the real estate market, but the whole economy as most businesses borrow money to make investments and grow.


Understanding that QE and lower interest rates increase liquidity, we now have the key to finding the cure to inflation: doing the opposite.


To cure inflation, central banks would have to shrink the money supply.


The first step should be raising the Fed fund rate higher than the inflation rate. This move would incentivize savings as people would be able to get positive real returns. Moreover, higher interest rates would make borrowing less attractive, decreasing the liquidity in the market.


The second step should be shrinking the Central Bank balance sheet by selling treasuries back to the open market. This action would decrease bond prices, increase interest rates on Treasuries and drain more liquidity from the market.


These actions, performed in a healthy economy, would fight inflation and benefit the population with lower prices and higher savings rates. However, performing these actions into a highly levered economy (as the one we have today) would create a complete disaster.


During the inflationary times of the 1970s, Paul Volcker had to raise interest rates above 20% to bring down inflation. Such a move would be completely impossible to do today. It would cause the biggest recession ever seen and bankrupt the US government.


The total US debt in 1970 was $371 billion. Today (end of 2021), it's $29 trillion. The debt to GDP ratio in 1970 was 35%. Today it is more than 130%.


When Nixon took office in 1969, the US ran a budget surplus of $3 billion. In 2020 the US ran a budget deficit of $3.1 trillion.


In the 1970s, the US could withstand tighter monetary policies. Today it cants. Today the US needs to borrow money to pay its creditors. If interest rates rise too much, it wouldn't be able to borrow and pay its creditors. It would mean defaulting on the debt.



The biggest Ponzi scheme?


Many regard Bernard Lawrence Madoff's Ponzi scheme as the biggest in history, worth about $64.8 billion. I would suggest a bigger Ponzi is happening now, right under the sun.


According to the FBI official website, a Ponzi scheme promises high financial returns in which "the con artist pays "dividends" to initial investors using the funds of subsequent investors."


By definition, I am starting to think that the US government might be running the biggest Ponzi scheme as it needs to borrow subsequent investors' funds to pay initial investors.


The Secretary of the Treasury Janet Yellen recently said, "America has always been a nation that pays its bills on time. It is essential that Congress act quickly to address the debt limit to ensure that remains the case. Congress cannot wait until the last minute."


To raise the debt ceiling to borrow more money to pay its creditors doesn't sound quite like paying its bills.


If a person has a $3,000 debt in his Visa credit card, then applies for an American Express credit card and uses the new card to pay the initial $3,000 debt, would you consider it as paying the bill or going further into debt?


I would consider it as going dangerously further into debt. Sadly is the only option for the US as it runs enormous budget deficits that don't seem to end anytime soon.



The debt problem:


Most governments worldwide are approaching the last part of the big debt cycle. The US is fastly approaching a point in which servicing its debt becomes difficult or impossible.

When a nation's debt rises too much, few difficult options are available to politicians.


1) Austerity (cut spending and paying down the debt with budget surplusses)


2) Increase Taxes


3) Defaulting or restructuring the debt


4) Printing money and inflating away the debt.


The first option is improbable to happen. The Biden administration has clear plans to increase social spending with their Build Back Better program, and it would be political suicide for them to reverse course.

Austerity would be highly unpopular as it would require cutting social security, Medicare, Medicaid, and many more promised benefits.


The second option (higher taxes) is likely to happen even though it would probably not be enough to solve the problem. The Biden administration repeatedly said that his tax increases would not affect everyone earning less than $400,000 per year, which means that he would only target the rich. However, the rich are very good at moving their capital and avoiding new taxes. The potential additional government income from raising taxes to the rich is overstated as capital naturally flees a nation with high taxes.

The only effective way to raise income from taxes would be to tax the middle and lower classes, which would find it difficult to avoid.


The third option, defaulting, would mark the end of the dollar as the world reserve currency. Investors would lose trust in the dollar, and the economy would get badly hurt. This option would be highly unpopular, and I doubt any US politicians would take responsibility for such a decision.


The last option is printing money to pay the debt. Historically speaking, it's the most adopted option by highly indebted countries. When a nation's debt is denominated in its own currency, it can easily print the money required to pay it. The US is the only nation allowed to print US dollars, and its debt is denominated in US dollars.



Why inflation will be substantial in the 2020s:


The US government has no other choice than inflate its debt away. It can't fight inflation for two simple reasons:


1) It would bankrupt the US government as higher interest rates would make servicing the debt impossible. It would also crush the over-levered liquidity-addicted economy. And it would create the worst recession in US history.


2) It doesn't want to fight inflation because it needs it. Otherwise, it would have already tightened monetary policies and increased interest rates.


For the above two reasons, inflation is here to stay for at least the next decade.


Central Banks know it, so they try to convince the people of the opposite. The Fed knows that controlling the narrative is crucial in this economy. They can't just say, "Hey guys, we can't pay our bills. We have to print money and create inflation to survive." otherwise, people would panic, and the dollar would crash.


What they like to do instead is lying. Even though anybody with some economic education could have predicted inflation, the fed spent the entirety of 2020 and most of 2021 saying inflation would be transitory. This assurance from the fed calmed the markets, which kept rallying.


At the end of 2021, with the CPI printing 6.2% yearly inflation, they finally said it was time to "retire" the word transitory and that nobody could have predicted inflation.


Now the Fed is saying that they will use their tools to fight inflation, but the reality is that if they could fight inflation, they would have already acted a long time ago.


The Fed is trapped and will not fight inflation. Even though they will probably raise interest rates from zero, real yields will be negative for years.


Therefore, investors must prepare accordingly for high inflation combined with negative real yields for years to come.



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