There is a lively debate among in-the-know economists and investors as to the outcome of the United States debt bubble, arguably the largest debt bubble in the history of the world: will this end in inflation or deflation? Everybody can agree that this will end badly, but the fundamental question of which direction the bad ending will go is very much up in the air.
The deeper you go down this monetary rabbit hole, the more you realize that this debate doesn’t have much to do your intellectual prowess on debt deflation or your grasp of the economic history of debt-liquidation inflation; it has everything to do with just one thing: the Fed. To what length is the Fed willing to go create the inflation they so desperately desire (and the US fiscal situation requires)? What will the Fed’s response be to the next recession and debt crisis?
The answer to the inflation vs. deflation debate lies in the mind, will, and emotions of central bankers… what does the soul of the Fed say? In short, the Fed mindset has been and remains: deflation over our dead bodies! As long as the Fed is alive and kicking, deflation will not happen on their watch. If there is ever even a hint of outright deflation, the printing presses with start rolling.
The Fed is right about one thing at least: you can always stop deflation by printing enough money. The forces of demographics, debt, and velocity of money can make it difficult to spur inflation, but deflation is avoidable. It is just a matter of how much money must be printed, and in what form (traditional QE or helicopter money?) In regard to deflation being preventable, sadly, I agree with the Fed entirely.
But the Fed is cornered. The next recession is not more than a year or two away. Short-term interest rates are already near zero. Monetary policy has reached its logical conclusion with 10 year Treasury rates below 2%. Negative interest rates are in the cards, but that policy is utterly foolish and clearly counterproductive, and would only exacerbate the recession. (But don’t get me wrong, the Fed might try it despite the clear ineffectiveness in Europe and Japan). So what is the Fed left to do?
Many argue that the Fed is “out of bullets”, that they will surrender and admit defeat. I beg to differ. It is true that tradition monetary policy (if you can call QE “traditional”) is out of bullets. But the Fed, in combination with the US treasury, has a whole new weapon to employ. That is, some form or another of helicopter money.
Fed inflation insanity was summed up well by Princeton economist Christopher Sims, who is not even at the Fed (but he will soon be chairman if he keeps talking like this). In a recent speech he said:
"Fiscal expansion can replace ineffective monetary policy at the zero lower bound. It requires deficits aimed at, and conditioned on, generating inflation. The deficits must be seen as financed by future inflation, not future taxes or spending cuts."
This is the future of Fed policy. First, it is the acknowledgment that monetary policy is ineffective at the zero lower bound. What a revelation! From there, it is a move towards “fiscal expansion”, which during a debt crisis and/or recession will undoubtedly be combined with Quantitative Easing, the combination of which is… you guessed it… helicopter money!
Reading between the lines, this is going to be an extreme policy move. The future Fed chairman is talking about “fiscal expansion” from the already enormous $500 billion deficits, and that “the deficits must be seen as financed by future inflation”. How much inflation is required so that the deficits are offset by future inflation? Well using a round number, this type of fiscal expansion will likely be a deficit of around 10% of GDP during a recession, so therefore inflation would have be 10% to offset those deficits.
Is it possible that the Fed will one day move from 2% or 3% inflation targets to more like 10%? Absolutely it’s possible, even probable. The US debt bubble, including unfunded liabilities, can only be resolved through inflation (assuming default is out of the question). With the fiscal gap north of $200 trillion, inflation needs to be high for a long time to inflate away that kind of debt. Perhaps 10% is just the start.
Inflation is coming. The Fed will not stop the monetary madness until they get the inflation they require. The only question that remains is this: will the Fed be able to control the inflation once it starts? The Fed thinks that they can control inflation like a thermostat; economic history implies that they are mistaken.
Uncontrollable inflation is coming. Are you prepared?