Remarkably, in a speech on monetary policy given at the Jackson Hole conference last Friday, Jay Powell never mentioned money, money supply, M1 or M2. The FOMC appears to no longer take the consequences of monetary expansion into account. But the fact is that rising consumer prices caused by monetary expansion have driven real rates sharply negative and are leading to pressure for higher interest rates.
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Introduction Last week, in his Jackson Hole speech Jay Powell grudgingly admitted that prices might rise a bit more than the FOMC previously thought. « Inflation at these levels is, of course, a cause for concern. » . This was followed by There is an associated problem, an enormous elephant in the room that no official seems to be aware of, which independent analysts such as John Williams at Shadowstats. Perhaps we should give Powell one out of ten for courage for participating at Jackson Hole, while zero points must be awarded to Christine Lagarde and Andrew Bailey, both having refused to take part in the symposium when at other times they would surely have welcomed the chance to be in the limelight on the global monetary stage. We are left wondering why they preferred not to justify their monetary policies in such a forum. But if Powell gets one point for at least appearing, he gets at least nine out of ten for evasion. Not even when discussing longer-term inflation expectations was money mentioned. The Fed’s monetary policy does not appear to involve money. To be clear, the chart in Figure 1 has nothing to do with rising prices, according to Jay Powell. Figure 1 shows narrow money supply before it was amended to include former categories of broader M2 money last February, rendering it useless for comparative analysis. Narrow money supply is going off the scales. Equally incredible is the gullibility of the investment establishment knowing that money does matter yet was drawn into the Fed’s non-monetary narrative. The relationship between prices and money Today’s masters of the monetary universe seem unaware of the fact. They have written many erudite books and articles, made speeches as we saw last week, in ignorance of or wishing away monetary facts. The consequences of debasement are therefore ducked. Interventionists dismiss the Cantillon effect, whereby prices increase in the wake of the new money being spent into circulation. Economic dislocation is part of and at the same time an additional factor to monetary expansion behind price increases. It arises from monetary inflation distorting markets, which continue to be disrupted by the covid pandemic. The Fed overseas two separate mechanisms for currency expansion. Quantitative easing is targeted at providing investing institutions with cash in return for low-risk assets, specifically US Treasury and agency bonds to the tune of $120bn every month. This QE has the effect of keeping bond yields suppressed and equity markets inflated because of the targeted institutions’ reinvestments. Fund raising for the government is about to become chaotic We can see that the Fed’s non-monetary approach to monetary policy begs important questions, but there are usually reasons behind it which we must consider. The latter task was made easier during covid lockdowns, since unspent income temporarily accumulated in the financial system, which together with currency and credit expansion led to the government being awash with funds. But that has now changed, as the balance on the government’s general account at the Fed in Figure 2 shows. Since March 2020, when the balance was $380bn, the government accumulated a further $1.437 trillion to a balance of $1.817 trillion in a little over four months, funded by a mixture of currency and credit inflation to fund extra government debt. This liquidity has been absorbed by the Fed’s reverse repo balances expanding to over a trillion dollars. The increase in RRPs had been necessary to prevent bank deposit and money market rates from going negative due to excessive liquidity. The effect on the dollar of the RRP level increasing has been to stabilise it on the foreign exchanges and to pause the headlong increase in commodity and raw material prices for the last few months. Assuming the debt ceiling will be raised in the coming weeks the US Government will resume selling US Treasuries and T-bills into the market to top up its general account and fund its ongoing deficit. The Fed may have a trillion up its sleeve in the form of RRPs which can be wound down. But the Biden administration is planning $6 trillion spending in fiscal 2022, rising to $8.2 trillion by 2031. Combined with a structural deficit, the government deficit next year will almost certainly be substantially higher than the Congressional Budget Office’s current forecasts. It all adds up to a recovery in tax revenues being postponed again, and government spending being increased more than budgeted, even before taking Biden’s proposed extra spending into account. The CBO’s optimistic assessment of the government deficit for next year is $1.153 trillion, reducing from over $3 trillion in the current year. Allowing for all the factors listed above, more realistically, another $3 trillion deficit is likely to be the minimum for fiscal 2022, which commences at the end of this month. Therefore, the simple problem is one of the Fed only being able to release one trillion of RRP liquidity into a market that will face demands for three trillion or more, being the likely fiscal deficit for 2022. We are back to where we were in March 2020, when the CBO forecast the deficit at $1.073 trillion, but the outturn was $3.13 trillion. With the Biden administration unable to reduce its budget deficit, a rising interest rate environment, reflecting price inflation, is bound to result in a funding crisis. These are the debt trap circumstances which not only deters foreign ownership of the currency but persuades foreigners to dump existing currency holdings in increasing amounts. It is the downside of the Triffin dilemma, when decades of irresponsible fiscal policy are encouraged to supply foreigners with a reserve currency. Inevitably, it ends with a currency crisis. The dollar has never been so over-owned by flaky foreign interests. The impact on the dollar While Powell hinted in his speech that tapering QE at some point is on the cards, it will simply not be possible if a similar budget deficit to this year is to be funded in 2022. Furthermore, in real terms interest rates are now deeply negative. 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 gold price moved from a low of $1450 to a high last August of $2075. In March 2020, official price inflation measured by the CPI 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. 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. 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 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. If the Fed loses control over rates, the bear market will be considerable. But the Fed is expected to keep economic confidence high. The John Law precedent If the inflation problem was simply one of runaway government spending, then the falling purchasing power of the currency would lead to ever greater demands on the printing presses. And the process would accelerate exponentially until the public realised there was no hope for the currency and hasten to rid themselves of it in a final collapse. This is the classic hyperinflation model, for which Germany’s well-documented monetary policies after the First World War are frequently cited. The policy is additional to interest rate suppression, which as I have pointed out above, is invaluable for the affordable funding of government deficits. John Law created a similar wealth effect through a combination of monetary inflation and the encouragement of asset speculation. What concerns us is the similarity with today’s QE and Law acting as a director of the Banque Royale, a prototype central bank, and controller of the currency. The reason prices rose was the livre was losing purchasing power due to its inflation. The natural rate of interest on Law’s unexchangeable paper currency was therefore increasing, which became the final nail in the coffin of the Mississippi bubble. The similarity with today’s intervention by central banks expanding the money quantity through QE to support markets is striking. It is a monetary policy, which initially suppresses the natural level of interest rates as the quantity of money increases, before it begins to lose purchasing power. As noted above, from the peak of the Mississippi bubble the currency collapsed with the bear market in the shares over little more than six months. The use of currency printing to support the market failed for the reasons we can expect to be repeated today. By ending in a market related crisis, the normal process of currency destruction reflected in the Weimar model becomes foreshortened. Gold The last time the consequences of Triffin’s dilemma hit the dollar was the failure of the gold pool in the late 1960s, which ended up driving the dollar off the last vestiges of a gold standard in 1971. If anything, the imperative to produce dollars for export accelerated as US monetary policy was to replace gold with the dollar as the international monetary standard. But one thing the US authorities could not wish away is the difference between a national currency and true money, the latter not being the product of credit creation. The benefit of a currency, to the issuer at least, is that it is the vehicle for transferring wealth to the government, its cronies, its licenced banks, and their favoured customers. Without currency, a government is severely limited financially. Gold is the money naturally preferred by the people. A state-issued currency alternative inevitably suffers debasement, which is generally tolerated so long as it is not acute. The compounding debasement of the dollar since the Nixon shock in 1971 has removed about 98% of the dollar’s value, measured against gold. The evidence strongly points to foreigners’ tolerance already undermined by the fall in the dollar’s purchasing power since March 2020. At the margin, commercial entities will again alter the balance between owning useful materials and holding dollar cash in favour of the former, leading to a renewed bout of price increases for commodities. But measured against commodity and energy prices, over the very long-term gold tends to retain its purchasing power, which is why when currency debasement accelerates, measured in fiat currencies the price of gold rises. Source: Alasdair Macleod | Goldmoney |
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