Will the Fed Defuse the Inflation Bomb?

Suppose you’re out for a walk one evening and notice that someone is stockpiling gunpowder at a warehouse in your neighborhood. So you and the neighbors start expressing concerns that if this keeps up, the place could eventually explode. “Nonsense,” says one person in the group (let’s just randomly call him Larry Kudlow). “I used to be worried about that too, but I was wrong. Just look at the warehouse. It shows no signs of exploding.”

Crazy, right? Tomorrow, next week, or next month, any joker who flings away a lit cigarette could cause a catastrophe. Just because it hasn’t happened yet doesn’t mean the danger isn’t there. But this seems to be the argument that Kudlow and many others have been making over the past few years regarding Fed policy and the risk of inflation.  The Fed has built a powder keg in the form of huge excess reserves at member banks, and it would only take a single spark to detonate an inflation bomb that they can’t control.

So as promised, here’s the second post in my case for raising rates.

 

Stimulus failures

First, a little history. Since the onset of the so-called great recession in 2008, the Fed, along with several other central banks around the globe, have tried frantically to boost the economy via monetary policy. In the last post I presented a whimsical, but essentially accurate, version of the  mechanics of how this works.

Basically, the Fed buys stuff with money it creates. Theoretically, the assets they buy could be cars, cashews, tubs, teddy bears, or anything at all. But so as not to roil the stuffed animal markets, they generally stick to government fixed income securities, which trade in volumes large enough to easily absorb Fed transaction sizes.

After 2008, under the various quantitative easing plans, the Fed began buying assets other than its normal instrument of choice, short term T-bills.  They bought billions each month in longer term debt, and even debt from other issuers such as mortgage-backed bonds, if memory serves. This was supposed to move money into the economy for lending, investment, and growth.

At the time,  much of the financial press (including Kudlow, who I think is generally on the side of the angels, even though I pick on him a lot in this space) were worried that all this stimulus money flowing into the economy would lead to runaway inflation as all those dollars chased a dearth of goods and services. I shared that worry.

But neither happened.

First, we didn’t see see the stellar growth that was the goal of the stimulus packages. Unfortunately, while the various quantitative easing programs and interest rate cuts may have prevented a financial collapse in 2008, the subsequent recovery has been among the weakest in history. Despite all the Fed’s efforts, we’ve only managed to achieve an anemic growth rate in the 2% area.  Around the world it’s even worse, with growing fears of another recession. Several countries have resorted to negative interest rates to combat the slowdown.

Secondly, we didn’t see inflation pick up at all, at least here in the U.S. What we did see was a rise in prices of financial assets like stocks. Globally we saw commodity prices rise, since they’re mainly priced in dollars. I argue that this led to high food prices in the Middle East and North Africa, which helped to trigger the Arab Spring revolutions.

So the new money didn’t get loaned out to fund growth. In order to get a return on it though, it looks like banks moved it into financial asset markets, possibly creating several Fed-fueled bubbles.

 

Powder keg

Meanwhile, I remember Larry Kudlow offering up a mea-culpa, saying he had been wrong about the inflation threat, and was now in favor of keeping rates low. This is where we part company on Fed policy. I think Larry was right to worry at first, but wrong to change his mind. The financial media like it when stocks go up though, so go figure. Yay for bubbles as long as our portfolios and ratings are rising!

However, the danger of an inflation explosion is still very real due to the powder keg of excess reserves sitting at banks.

So why haven’t banks used those reserves to increase lending to businesses as described at the end of my thrilling screenplay?  I’ve already discussed that in a prior post, but to summarize, it takes two to tango, and businesses aren’t willing to borrow, take risks, and expand under a socialist president who has been attacking them for almost eight years.

Ok, but there’s an election coming up. What happens if a free market advocate like Ted Cruz wins? While I’d do virtual cartwheels down a virtual street, I’d be quite worried too. The crowd goes wild, Larry Kudlow’s “animal spirits” return to the economy, and entrepreneurs fall all over themselves to borrow, invest, innovate, and hire…spark!

Boom.

That could very well be the trigger that releases all those piles of reserves into the system, causing inflation to suddenly blast off.

Luckily, it seems that the Fed is already trying to buck popular opinion and get onto a gradual tightening track, probably to forestall such an event. That’s a much more believable scenario than the silly one I discussed a few weeks ago about Yellen just wanting to have a unique legacy in the history books.

No, I think the Fed may be seeing signs of an accelerating economy. I certainly am. Just this weekend, my fundamental analysis system (which I’m describing in an upcoming book) showed a sharp spike in the fundamental potential of the U.S. dollar.

The Fed may just be trying to dismantle that excess reserves powder keg before it gets set off. Last night I also heard one of Larry Kudlow’s guests say that they would advise the Fed to unwind this thing as well. The analogy he used was backing slowly out of a room that you know you don’t want to be in.

So that’s the case for raising rates. The Fed needs to sell off the assets on its books, thus unwinding those excess reserves at the member banks. That would dry up the potential money supply and normalize rates in the process. What more could a carry trader ask for?

Until next time…keep pipping up!

 

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