The Next Inflation Wave Will Not Be Transitory: Waiting For The Next Shoe To Drop

Inflation has plummeted from its 9% high in June 2022 to its current 3%. It was transitory, lasting just 3 years. This decrease would have occurred without Federal Reserve actions because supply chain disruptions caused by COVID were destined to get resolved as shipping containers eventually got unloaded. This form of inflation is called “Demand-Pull.” It is caused by demand for goods and services exceeding supply.

Although it was not needed to control inflation at this time, it is time for the Fed to take its foot off the interest rate brake in its Zero Interest Rate Policy (ZIRP) because the real inflation fight is approaching, and it will require all the weapons in the Fed’s arsenal.

The next wave of inflation – the BIG one

The other form of inflation, called “Cost-Push,” is not transitory. It is classic inflation caused by too many dollars chasing too few goods. It happens when a government prints too much money, as has been happening globally over the past decade.

Argentina and Venezuela are rich countries that are still suffering from hyperinflation, defined as inflation above 50% because their governments made serious monetary mistakes that the US is repeating.

The world is running on unprecedented levels of debt, to the tune of $200,000 per capita. The US enjoys a special status as the “cleanest dirty shirt in the laundry basket” because the US dollar is the world’s reserve currency, so we enjoy a special privilege that provides some insulation, but we are not immune from inflation. Also, China could be colluding with Russia to make the Chinese yuan the world’s reserve currency.

The US has printed more money for COVID than any other country, exposing it to cost-push inflation that will last a long time and will drive inflation above the current 3%. It’s the next wave.

Who is paying for COVID? When was the last time you heard the words “balanced budget”? COVID relief has a colossal $5 trillion price tag.

“Modern Monetary Theory” (MMT) is the purported justification for the money the US has “printed” over the past 15 years since 2008. The theory says that governments who own the printing press can print all they want to solve economic crises unless it causes inflation, in which case that money needs to be taken back with taxes.

The money supply is currently $3.5 trillion above what is needed to support economic activity. “Excess money” will drive cost-push inflation in the next wave. The “trend” shown in the graph below is the money supply needed to keep the economy running smoothly. The “actual” shows the excess, also known as “too much money.”

There is little political will to suck that money out of the economy with taxes, so inflation will persist.

MMT appears to have “worked.” A recession in 2008 was short-lived, stock prices soared, and inflation remained near zero — until recently. We are currently experiencing a mix of Demand-Pull and Cost-Push inflation that is transitioning to mostly Cost-Push.

A couple videos explain the craziness in a clear and humorous way. Debt limit – a guide to American federal debt made easy uses household debt to explain federal debt. Fred Thompson on the Economy explains the wisdom of Quantitative Easing to save the 2008 economy.

$3.5 trillion excess money is a lot, but the Multiplier Effect expands this into $35 trillion, which is 150% of GDP and 100% of our total debt. One $trillion is 1000 billion or a million million — it’s a huge amount of money According to CNBC:

If you paid out $1 per second, to settle a $1 million debt would take less than 12 days. To pay off $1 billion would take 32 years. Paying off $1 trillion at a dollar per second? 32,000 years.

A trillion is a 1 followed by 12 zeros, like this: 1,000,000,000,000.

A trillion square miles would cover the surface of 5,000 planet Earths.

A trillion people would be 10 times more than have ever lived (based on the Population Reference Bureau’s very rough estimate of 108 billion humans ever).

A trillion dollars is enough to give $3,195 to every man, woman, and child in the United States. (Author’s comment: we actually got this helicopter money doled out in bigger checks)

For a typical U.S. household, making $50,000 per year, to earn enough to pay off a $1 trillion debt would take 20 million years.

Piling on

The following graph shows the magnitude of recent money printing by comparing it to our most expensive wars.

But that’s not the entirety of the debt story. We (through our government) have made promises for Social Security and Medicare that are unlikely to be kept, and Quantitative Easing has widened the wealth divide beyond comprehension.

The following image shows that the total US debt is more than 5 times the gross domestic product (GDP) when the total includes off-balance sheet promises for Social Security and Medicare.

Tax receipts for Social Security have been insufficient to pay all the benefits since 2018. The Government Accountability Office (GAO) reports that Social Security will be bankrupt in 2026, followed by Medicare in 2034. Many say that owning the printing press means you can’t go bankrupt, but the reality is that inflationary forces are already out of control.

MMT has poked the inflationary bear, and it is infuriated. Cowboy wisdom instructs “When you find yourself in a hole, stop digging.” That is the Fed’s current mission.

The Federal Reserve is the arsonist charged with putting out the inflation fire

It’s ironic that the Fed is coming to the rescue to control inflation when it is complicit in creating it.

“Printing” is not actually running the presses. The US Treasury borrows money as Treasury bonds and bills. In ordinary times, there are plenty of buyers for these bonds, but recent times have not been ordinary, so the Federal Reserve buys them, manipulating bond prices to execute a Zero Interest Rate Policy (ZIRP). In this way, money is created out of thin air.

According to the Federal Reserve, its balance sheet has skyrocketed from normal levels under $1 trillion to $8 trillion currently, with most of the increase during the pandemic.

Warren Buffett praised the Fed for saving the economy in 2008 with its QE but cautioned that unravelling the huge buildup of the Fed’s holdings in bonds could have disastrous consequences. In other words, tapering is dangerous, and the greater the buildup, the greater the danger. The Fed is playing with fire, as shown in the following.

The Fed does not have a dial that it can turn to a desired level of interest rates, but it has managed to suppress interest rates by buying bonds at premium prices. When the Fed lets its foot off the brake by tapering its bond-buying, interest rates go up and bond prices go down because the Treasury must attract other buyers by sweetening the pie.

No special Fed meeting is required to “set” an interest rate — rates rebound toward a fair market price when they are not being suppressed. A fair market price in a 3% inflationary environment yields 6%. We should expect inflation to increase above the current 3%, causing interest rates to increase again.

Increases in interest rates do a lot of damage, as we learned in the 2013 “Taper Tantrum.” Higher interest means higher payments on our $34 trillion government debt. Interest at 6% would require spending 84% of tax receipts on debt service, leaving little for other expenses so deficits will skyrocket to $5 trillion per year, which is 3 times the current $1.8 trillion. Tax receipts are about $4.5 trillion per year. The debt clock will spin out of control.

What’s worse is the stock market will crash, as it almost did in the 2013 Taper Tantrum because bonds become attractive alternatives and corporate earnings are discounted at a higher rate. At this stage in the cycle, the Fed will be encouraged to stop tapering and resume its bond buying. The market expects this “pivot” to occur soon, again.

But this time is not like 2013, when inflation was near zero. This time Fed bond buying will fuel the very inflation fires that the Fed is trying to extinguish.

The Federal Reserve cannot simultaneously continue to manipulate interest rates under ZIRP while subduing inflation. It will have to choose. The better choice is to allow bonds to return to market-driven prices, increasing interest rates and driving down stock prices. Allowing market forces to work is the best choice even if it causes pain in the short run.

As proclaimed in a Chiffon margarine commercial, “It’s not nice to fool Mother Nature.” Markets are best left to establish fair prices.

Conclusion

Market pundits have declared an end to inflation that has launched a stock market rally – the Santa Rally –in anticipation of a Fed pivot. But the Fed historically has lowered interest rates to buoy up a falling stock market – to stimulate stock investing.—rather than to fuel a rising stock market. The Fed should let the market determine fair prices for stocks and bonds. It should abandon ZIRP.

We’re ignoring lessons that should be learned from recent stock and bond market advances. Ignorance is not bliss.

Investors should prepare for the next wave of inflation by moving to inflation protection like TIPS and other assets that are not stocks or bonds.

Editor’s Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.