"Where's the inflation you've been warning us about, Porter?" So says the imaginary chorus of readers who follow me around, haunting the quiet and introspective moments of my life.
I can't ignore them ... and so I answer: Right in front of you! Then, my wife asks me, "Porter, who are you talking to?"
Here are the facts. An index of producer prices (the PPI) fell 0.6 percent last month – the biggest drop in wholesale prices. This small decline in prices along with the Fed's recent comments that it sees no reason to raise interest rates anytime soon has led stock investors to believe we may be back in what's commonly called the "Goldilocks scenario."
In this situation, the economy is not too hot or not too cold – it's just right.
Folks who believe in Goldilocks (and other children's fantasies) would have you think the Fed can continue to inflate the U.S. economy through massive manipulation while the U.S. government continues to borrow 10 percent or more of GDP per year – forever – without any negative consequences. And therefore, equity prices should go much higher. That's why we've seen stocks move relentlessly higher. The S&P 500 is now up about 70 percent since the bottom last March.
What most people don't understand about inflation is it's not really a measure of commodity prices. That's only how the government chooses to measure inflation. Inflation has one true meaning: the increase of the money supply above the savings rate. Inflation isn't caused by a shortage of wheat or corn or oil, it is caused by one thing and one thing only: central bankers shrinking their reserve ratios.
One year ago the grand total of the Federal Reserve's bank credit was $1,989,877,000,000 – including $508,592,000,000 of securities (of dubious value) it purchased on the open market. Today, the Fed's total bank credit is $2,234,676,000,000 – including $1,912,690,000,000 of securities it purchased on the open market. The Fed, as promised, has spent an enormous amount of money buying mortgages and Treasuries over the last year. When central banks buy government debts or other credits, economists call it "quantitative easing," or monetizing. But you and I would simply call it printing money.
So over the last year, we've seen the Fed inflate by at least $250 billion. An increase of $250 billion in bank credit is roughly a 10 percent rate of inflation, based on the Fed's total credit. During this period, foreign holdings of our government's Treasury obligations increased by roughly $500 billion. (Our government debts far exceeded our domestic savings.) Thus, it's clear that, as a nation, we had zero net savings and the entire expansion of the Fed's balance sheet was inflationary. The impact of this inflation could be mitigated by increases in productivity. According to the latest data, productivity increased at almost a 6 percent rate in the most recent period, adjusted for various seasonal factors.
You, too, can be an economist ... if you were going to guess what the likely effect on prices would be, across the entire economy, what number would you come up with? You've got 10 percent inflation minus about 6 percent productivity growth. That would leave you with about a 4 percent change in prices, right? So what was the change in PPI prices over the last year (not just the last month)? The PPI was up 4.4 percent compared to a year ago. Bingo.
Now, let me ask you a simple question. Today, the yield on 10-year U.S. government bonds is around 3.65 percent. You know for a fact the Federal Reserve monetized a huge amount of debt over the last year, increasing the size of its balance sheet by roughly 10 percent. You know the U.S. economy – despite shedding a huge number of workers – wasn't able to keep up with that inflation in terms of productivity. As a result, the value of our currency in our own economy fell by roughly 4 percent. Why on Earth would you buy the securities of a deeply indebted nation when the yield on its bonds doesn't even cover the rate of depreciation of its currency? You wouldn't, of course. That's why China, among other foreign creditors, has begun to sell.
Now, if you're not going to buy Treasury bonds because the yield isn't keeping pace with inflation, what else might you purchase? The U.S. has a tremendous account deficit because we continue to consume far more than we produce. The most recent figure I could find was $108 billion from the third quarter of 2009. So our foreign creditors have to buy something with their dollars, roughly $100 billion worth each quarter. If they're not going to buy Treasury securities, you might expect them to buy commodities, gold, or maybe even equities.
Over the last year, gold is up about 20 percent. Silver is up about 30 percent. Copper is up 95 percent. Oil is up 64 percent. U.S. stocks are up 70 percent. What's down? Government bonds, about 10 percent. Where in our economy would you say inflation is affecting prices? When people tell you there's no inflation, try telling them to look anywhere besides the official government statistics.
My warnings about inflation aren't because I fear a 10 percent increase in the Fed's balance sheet. If increases of that size continue year after year, we'd eventually get in trouble, but the bigger risk is the effect of the U.S. government's fiscal policies. Quite simply, we are unwilling to pay for the size of the government we're demanding. Our government's soaring debts will have very real consequences.
Putting additional strain on our government's credit rating is the fact that over the last two years, we replaced so much of the country's private balance sheets with the public balance sheet. GE, for example, relies on a $500 billion guarantee for access to the credit markets. Fannie and Freddie underwrite 90 percent of mortgages. GM required a $100 billion bailout, as did AIG, Merrill Lynch, and Bear Stearns.
Sooner or later, our government's creditors are going to be struck by the fact that not only are they not being paid a fair rate of interest for our Treasury bonds, they are also unlikely to ever be repaid the principal amounts of their loans. When that realization hits, the Federal Reserve will be forced to monetize a substantial portion of the Treasury bond market. That will be a very bad day for investors...
When is this going to happen? Yogi Berra famously said predictions are hard to get right, especially about the future. And I would posit the Stansberry Corollary to Berra's maxim, "It's even more difficult when the Federal Reserve is manipulating the future." So I can't tell you when. It all depends on how fast our debts grow compared to our economy and how long our creditors remain willing to take a chance on us. But when I'm asked this question, I simply point out what's obvious to me: If you knew you were riding with a drunk driver, when would you ask to be let out of the car?