SEMI-MONTHLY FISCAL/MONETARY REPORT- CAN THE FED “CONTROL” THE SITUATION?

The capital markets traded to the upside in April, as the Biden administration lays out their agenda and the Federal Reserve assures everyone that they continue to have everything under control. We suggest that you come to your own conclusions. Ben Bernanke had no clue that the financial crisis of ’08-’09 was coming, though there were quite a few warning bells ringing. You never know which snowflake will start the avalanche.

THE DEFICITS AND THE DEBT

For those of you that like to know the latest deficit and debt numbers look like, the US deficit for the month of March was $660 billion, up from $119 billion in ’20, just before the pandemic related spending took off. The deficit for the first six months of the current fiscal year has therefore been $1.7 trillion, up from $741 billion in ’20. Since the comparisons from here will be up against the huge spending from April through September of the fiscal year ending 9/30, the comparisons will be “tougher”, depending on what stimulus programs are implemented.

Safe to say that the deficit for the current year ending 9/30/21 will be substantially more than the $3.1 trillion of last year. No doubt the total debt, not including unfunded entitlements, will be in the area of $30 trillion somewhere in the fourth calendar quarter of 2021. This continues to be of prime importance because heavy debt burdens the recovering economy and enormous spending, mostly financed by our Federal Reserve’s currency creation, will be necessary to keep the economy from collapsing. With the 2022 very important congressional election season beginning in just a matter of months, you can bet that the Biden administration will spare no expense to make the economy look good.

INFLATION OR DEFLATION?

There is an increasingly active debate developing as to whether inflation, or possibly some form of deflation, is in our future, and when. Keep in mind that both can happen, just as we have already seen higher prices in assets such as stocks, bonds, real estate and others. On the other hand, general income levels have not moved by much and “core inflation”, excluding food and energy, is still subdued.

Both inflation and deflation can be good for gold. The miners did very well during the deflationary 1930s, in spite of a fixed gold price, because their costs were coming down as the worldwide economy collapsed. Gold did even better in the inflationary 1970s, moving from $35 when Nixon eliminated convertibility in 1971 to $850 early in 1980. On balance, we prefer inflationary trends and that is what central banks around the world are desperately trying to provide.

There are some very obvious short term trends that point to inflation. There is major upward pressure on the minimum wage, with an apparent shortage of workers. There have been shortfalls in supply, and higher prices for semiconductors, lumber, copper, agriculture, gasoline, used cars, and housing. Interest rates, while still low, have moved upward, which could signal the bond market’s expectation of higher inflation. The M-2 money supply has moved up by 24% in just the last year, the most rapid rate in 150 years, and economics 101 dictates that more money chasing the same amount of goods should be inflationary at some point. Most importantly, consumers increasingly expect inflation to accelerate, and that expectation alone can be a critical ingredient. Lastly, the weakness in the US Dollar points to higher domestic inflation.

On the other hand, some of the most intelligent observers, including Lacy Hunt, Gary Shilling, and David Rosenberg, believe that the likely inflation coming out of the pandemic, over the next six months, will be modest. Fed Chairman, Jerome Powell, calls it “anchored” and “transitory”. Hunt and Schilling have had three decades of accurately calling for low interest rates, a sluggish economy, and subdued inflation, largely as a result of the debt burden. David Rosenberg, perhaps the economic commentator with the most well documented view, is looking for a short term economic bounce, accompanied by a modest uptick in inflation, but a return to economic malaise within six months.

Powell believes the Fed can control inflation by reversing the accommodation, allowing interest rates to rise, just as Paul Volker did in from 1979 to 1982. Hunt and Shilling and Rosenberg believe that the economy will go nowhere because of the debt and the aging demographics. The debt, in their mind, is a huge problem over the long term, but the Fed activities preclude a full scale  economic collapase. It seems to us that one of the most important ingredients in the reasoning of Powell, Hunt, Shilling and Rosenberg is that inflation is been “anchored” for the last ten years, even though the deficits and debt have gone through the roof. Therefore: the same beat can go on for the foreseeable future.

Though these are very smart people that we are trying to interpret and “second guess” to a degree, we are inclined to think that inflation will be higher, and longer, than is suggested above. Historical precedents may not apply because this monetary experiment is of a different magnitude than has ever been seen before.

Firstly, the Fed can’t “pull a Volker”, if inflation takes off, because the $28 trillion of debt now compares to $1 trillion in 1980, and today’s many trillions of unfunded entitlements were of little concern forty years ago. The annual operating deficit was only about $100 billion in 1980 compared to perhaps $4 trillion today. Even with an economy that is 6-7 times larger today, the problems are of a different order of magnitude. Raising interest rates, as Volker did, would trigger a massive decline in asset prices and a terrible depression.

The assumption by Powell and the others is that, based on the lack of inflation the last ten years, as deficits and debt built up, there is reason to believe that further monetary accommodation will, similarly, not create an inflation problem. We have seen that, though the Fed took its balance sheet from $1 trillion to $8 trillion in the last ten years, financing most of the annual deficit with newly printed dollars, the “velocity” of the monetary aggregates collapsed at the same time so the new currency did not pressure the CPI upward.

The Fed wants 2%+ inflation, and $7 trillion of new currency did not get the job done. In an extreme example, do you believe that $100 trillion of new currency, chasing the same amount of goods and services, would drive prices higher? We would say: highly likely. Seven trillion dollars didn’t get the job done. One hundred trillion dollars probably would.

The only remaining question becomes: What amount of new currency, between $7 trillion and $100 trillion, would kick off inflation? We think we are going to find out. Nobody knows how the above discussed elements will interact, but we expect a stagflationary period during the foreseeable future, likely with an even weaker economy and higher inflation than in the 1970s.  We also expect gold and the gold miners to be among the very best asset classes to own in the turbulent period ahead.

Roger Lipton.