Another Fine Mess The Fed Has Gotten Us Into

 Laurel and Hardy had a catch phrase with variations on "well here is another fine mess you have gotten me into".  The Fed has blown many bubbles since it was created over 100 years ago but this is the first "everything bubble" and a really fine mess.

The core problem is that the bubble economy and government are now dependent on interest rates that are near zero but these low interest rates are causing inflation.   The Fed's duel mandate of high employment and stable prices requires that they raise interest rates to fight inflation.   But this is likely to pop the everything bubble.

The Fed is targeting 2% inflation.  The latest CPI reading was 6.8%.  It has been going up very quickly.   The current CPI uses owners equivalent rent, where they go around asking non-renters what they think their house could rent for.  This is just just aggregating made up numbers and not collecting real housing price data.  People experience real inflation and not the made up numbers.  If you use real housing data, like they used to, the CPI comes out to 11%.  There are other tricks in the CPI that cause it to understate inflation.  Really inflation is at least 9% above the Fed's target.  

There is a Taylor Rule for figuring out what interest rate the Fed should use to get inflation back to its target rate.  It is easy to try out the Atlanta Fed Taylor Rule Calculator  to see what rate should be used.   But really you should have 2 or 3% more than the current inflation rate.   The only way Paul Volker could control inflation was by raising interest rates above the inflation rate.  We really need something like 13% interest rates to control this inflation.  Staying near 0% will encourage more inflation.

Some people ask, "how could increasing interest rates fix supply chain problems?".   The wrong idea here is that the current inflation is just caused by supply chain issues and these are not things the Fed can fix.   Let me try to explain.   Imagine each businessman is seeing various costs for his input supplies going up at  numbers like 10%, 15%,  25%, 50%.  Also imagine that banks pays him 0% if he leaves the money in the bank and charges him only 2% if he borrows money.  The rational thing for him to do is order extra of his input supplies, either with cash on hand or by borrowing.   In these conditions he is better off using these input supplies as a store of value.   With 0% interest and these inflation rates, the dollar is not a "good store of value".   The dollar has lost one of the key attributes of good money.   But the supply chains were designed for normal monthly supply quantities and not for businesses also using supplies as a store of value.  This additional usage is too much.    If interest rates were at 13% many more businessmen would use money as a store of value instead of input supplies.  If the Fed raised rates to 13% the supply chain would be fixed right away.  Really. 

When the local money fails as a store of value, you always see laws against "hoarding" as if that was the core problem.  Hoarding is a symptom of bad money, not a core problem.

It is also not clear to many people how the Fed has caused the labor shortage, so let me try to explain that as well.  By dropping interest rates to zero the Fed has about doubled the stock market since the 2020 low.  This has made many people feel rich enough that they think they don't need to work, so they quit.   If the Fed were to increase interest rates, probably the stock market would crash, and many of these people would be looking for work again.

The US Federal Government has over $29 trillion in debt.    These days much of it is short term T-bills and not long term Treasuries.  If interest rates went to 13% the interest could be more than the total taxes collected.   Many companies and individuals have also taken on lots of debt to take advantage of the low interest rates.   If rates go up they will have a very hard time.

The market is only expecting two rate hikes of 0.25% each in 2022.  The market is thinking we will be at 0.5% interest 12 months from now.   This is nowhere near high enough rate to fight inflation.  Inflation has been going up 0.5% per month many times recently.  Without some serious effort to fight inflation soon, we will see far higher inflation by the end of 2022.     On the other hand, even 2% rates now would no doubt crash the stock market and slow the economy way down.   It is another fine mess the Fed has gotten us into.

Inflation Going Higher

The Nov 2021 CPI report comes out Dec 10th.   The Oct CPI was 6.2%.   Here are three different estimates for Friday's number:

1. Cleveland Fed estimates 6.6%
2. Lyn Alden says  economists are estimating 6.7%
3. Trading Economics forecasts 6.9%

As Edward Garbarino commented in response to Lyn's tweet, "If Powell did not have information indicating significant worsening inflationary pressure on the horizon, he would not have jettisoned the "transitory inflation" narrative, IMHO."

This year the real CPI numbers have surprised to the upside many times.  We may be at 7% or more on Friday. 

People are expecting that about a 0.5% increase in the Fed Funds rate in 2022 will tame inflation.   This is naive.   Given how fast inflation has been going up (frequently 0.5% per month) that is far too slow a pace of increasing interest rates to ever get ahead of the inflation rate.   If interest rates stay far below the inflation rate, inflation will continue to go up.  Interest rates need to be well above the inflation rate to be "fighting inflation".

Historically when inflation starts going up the Fed tightens and the market goes down.  It really seems that this is likely soon.

However, if we have 7% inflation then it would take something like 10% interest rates to get control of it.  If we had such rates the economy would be dead and the government bankrupt.   But if interest rates stay low, inflation can get out of control.  It really could go to hyperinflation.  Either choice the Fed makes has a really bad result.   There does not seem to be any nice way out at this point.

Private Economy is the Real Economy

 

Government economists define GNP to include government spending.   This way the more government spending, the higher the GNP.   So if they need to "grow the economy" all they have to do is increase government spending.  The more the government is spending, the more power they have. 

The reality is that government is a leach on the real productive economy.  They are taking resources from the productive parts by taxation and money creation (inflation).   Government does not add to the economy, it sucks life out of the economy.   

If we subtract government spending from the official GNP and scale for inflation, we get the following graph which gives a better idea of the Real Economy.

First, looking at this graph it is crazy for the stock market to be up by about a factor of 7 in the last 12 years.   The real economy is not doing anything close to that kind of growth.

Next, the idea that government spending fixed the recession last year so it was only 2 months is silly.   Sure they got the "official GNP" back up, but the real economy is still way down.

Graveyard of Empires

 

Biden and others have called Afghanistan the Graveyard of Empires.  There are a number of definitions of "empire" but here we will use:

   Empire:  A government that collects taxes from other countries.

By this definition I believe the USA is an empire, though using a tax very few recognize.   As Keynes put it:

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens.

After world war 2 the US dollar became the world reserve currency.   Since then Central Banks, businesses, and people all over the world have been using the US dollar and holding US bonds.   As the US prints more dollars, they are really collecting a hidden tax on dollar holders all over the world.   This is a most diabolical tax, as it is so secret and unobserved.   This "inflation tax" has gone on for more than 70 years.

Recently the pace of money printing has increased to trillions per year.   This may be getting to the "evil empire" stage, where there is a tax revolt. 

The fraction of US debt held by foreigners has been dropping recently:

Source:  Fred

If enough people realize that holding dollars makes them subject to this tax, and so decide to no longer use the dollar, we could easily get hyperinflation.

The rest of the world could leave the dollar for something else.  For example, other central banks could use gold as reserves to back their own currencies.  Gold is what was used before the dollar and could work again.  A number of central banks do seem to be buying gold faster recently.   For international settlement, Bitcoin could work.    No doubt such a major change will be chaotic for awhile.  After the change most of the world could be better off, as they would no longer pay the US dollar inflation tax.   However, the USA will be much worse off, as they will no longer collect this huge inflation tax from the rest of the world.

Like other empires that failed after failing in Afghanistan, probably the American Empire is coming to an end.  

 

Devil in the Details

 The low on the S&P 500 in 2009 crash was 666.   If we multiply that by 6.66 and round off just a bit we get 4444.    A factor of 6.66 in 11 years should qualify as "frothy".  Seems like 4444 is a good number for a high. 

Extreme Valuation and Crash Warning Charts

 

They say "no one rings a bell at the market top".   But there are signs that things are higher than normal or getting shaky.  I am collecting links that show charts indicating extreme stock, bond, or real estate valuations or things that often come before crashes.  If you know of other such links that you like, please comment and I will add them to the original post.  Thanks.

1. How to Spot a Bubble, March 2021, Hussman
2. Crescat Capital March Research Letter
3. Shiller PE, gurufocus
4. Buffett Indicator, gurufocus
5. Goldmen Sachs Non-Profitable Technology Index, Robeco 
6. Is the Market Still Overvalued?, Advisor Perspectives, 8/21 
7. CurrentMarketValuation.com 
8. P/E and inflation, Advisor Perspectives, 8/21 
9. 14 Warning Signs That a Stock Market Crash Is Coming, moneycrashers.com 
10. Stock Market Crash, Fragility And Silence, seekingalpha.com 
11. This one signal says a stock market correction may be on the way, marketwatch.com
12. Whole Lotta Love: Sentiment’s Potential Warning, schwab.com 
13.  What Triggered the Crash?, John Hussman, 7/20/21 
14. Alice’s Adventures in Equilibrium, John Hussman, 6/21
15. Grantham:  This is a bubble, this is serious 
16. Warnings about a stock market crash are growing louder, timesnewsexpress.com 
17. These 23 Charts Prove That Stocks Are Heading For A Devastating Crash,  July 2014
18. The Folly of Ruling Out a Collapse, Hussman Aug, 2021
19. Recession Alert! Morgan Stanley, Rabobank, Normura, & BofA Warn Investors a Crash is Coming Aug 25, 2021
20. Four Reasons the Next Recession Will Be Worse Than the Last One 9/10/21 
21. Technically Speaking: The Markets Next “Minsky Moment” 7/27/21 
22. The Beginning Of The End -Alasdair MacLeod 10/11/21
23. When Bubble Meets Trouble - Hussman 11/9/21
    

From the above, I think one of the most important charts is:

 

At the current inflation level we have never had such a high P/E before (yellow box).   If inflation gets higher this P/E will be even more extreme.

Inflation Expectations are Never "Well Anchored"

 

Jerome Powell keeps saying, "inflation expectations are well anchored".   This "well anchored" makes it sound like they can't easily change.

 The reality is people expect inflation about like the current inflation.  As seen in the graph below, if the CPI (green line) goes up, as it has the last 4 months, people's expectations goes up too (blue line).   For Powell to think it it safe to print money because people are not expecting much inflation at this moment is foolish.   People's expectations can change in a month but the "long and variable delays" from policy change to inflation change  can take years.

Inflation can get into positive feedback loops that are very hard or impossible to control.  The central banker needs to take a long term view, because inflation responds so slowly to their policy changes.   It is irresponsible to make decisions about money creation based on a short term and fickle measure like people's expectations.  

The reality is that people's expectations are never "well anchored".  If we get CPI numbers of 6% or 7% then inflation expectations will move to that range also.   Maybe then Powell will stop saying, "inflation expectations are well anchored".

How Fed Fights or Encourages Inflation

 

When Paul Volcker fought inflation, the way he did it was letting interest rates go higher than the inflation rate.   The graph below has 10 year interest rate (blue), the inflation rate (red), and then the difference between these (green).   When the green line was far below zero Volcker was fighting inflation hard.

However, when the green line is near zero or above zero, the Fed is encouraging inflation.   In the 1970s the green line was near zero or spiking above zero.  This was encouraged the inflation of the 70s. 

As Milton Friedman taught, inflation is always and everywhere a monetary phenomenon, but there are long and variable delays between Fed policy inputs and the inflation result.   It can take years for inflation to show up, or go away, after a Fed policy change. 

For the last few years the green line has been near zero and above, similar to the 1970s.   Having interest rates below the inflation rate is once again encouraging inflation.    Inflation is starting to show in measures like the CPI.

Intuitively this makes sense.   If it is possible to borrow money at rates below the inflation rate then lots of companies and people are going to borrow money, which will cause the banks/fed to increase the money supply, which will cause more inflation. 

Debt to GDP

 If we add up government debt, corporate debt, and household debt and divide by GPD we get a the following graph:

The total debt/GDP ratio is almost 3 times what it was in 1980.   In 1980 it was possible to survive with high interest rates but today high interest rates with these high debt levels would be horrible. 

 

 

Last Call for Punch Bowl?

 

The grey areas in the graph below are recessions.  Note how whenever inflation is above 3% and going up fast it suddenly goes down and there is a recession?   The Fed has to take away the punch bowl as part of its mandate is to control inflation.  When it does this there is a recession.   Note we are above 3% and going up fast.   People think the Fed can keep the same easy money policy for the next two years.  Inflation would be way too high if they do that.  This should be last call for the punch bowl.

 

Fred Graph of CPI:

 You can also see this in a graph of the PPI:

These two graphs make it look like there should soon be a recession.

However, this time it may not be possible to take away the punch bowl.   The Federal government is spending twice what they get in taxes and has huge debt.  They need the Fed to keep buying their bonds and to keep interest rates low.  If not for the Fed the interest rates would be much higher.  If interest rates on the debt were 5% it would take about half the taxes just to pay the interest.  In this case the Federal spending would be about 4 times the income left after paying interest.    They would be clearly insolvent and nobody would want to buy their bonds.  They really need the Fed to keep buying.   But if the Fed keeps buying then inflation will get out of control.   Probably inflation will get out of control.

It is strange that people can see the government making trillions of new dollars and then be surprised when inflation comes.   If you survey your friends, I bet your Libertarian friends are less surprised than your Democrat friends.