Inflation And The ‘Fed Put’ Is Here To Stay

If the old orthodoxy has any sway left in the modern economic landscape it aims for balanced growth. For a while there it did great until the “global financial crisis” blew a hole in it.

The very base case was and still is that government will tax and spend as much as it can rather than as much as it needs. Then government borrows on top, which in a way underlines it has reached its practical limit on taxation but is happy to expend even more. This borrowing on top is meant to match growth. So if there is 3% growth, which is/was the magic target, you can borrow 3% of GDP in each year and give or take, the national debt stays in balance with the economy. Now if you target a 3% inflation, it juices up growth and actually chips away at the national debt in real terms and with a bit of luck you can get back to a level of debt to GDP that is optimal for growth. It’s a reasonable plan.

The scheme is in a sweet spot between austerity and South American economic carnival. It is a positive way to try and build an economy. Of course, in practice it often doesn’t go to plan. Inflation misses one way or the other, the government goes on a spending bender and growth does not go as fast as hoped. So the debt to GDP ratio grows and economic growth slows and… and… and…. Then when you get a Covid situation, the tight rope act that is government budgeting comes unglued.

This is where the inflation solution comes into play. You can’t make your budget from tax, so you have a giant deficit, so you are forced to print money and hand it out to make up the difference. Government may pretend to borrow it, it may even borrow some of it, but it will be forced to print most of it.

Only the printing press of governments can create inflation, no matter what excuses are fielded. Debt is monetized, cash is printed and various other IOUs swapped about. This is why so many countries all around the world have high inflation, because it is easier to spend printed new money than to set and collect tax.

Now you have to grasp that the people doing this are no fools. They know exactly what they are doing and it is done for a reason and it is not a mistake. All the stuff you read about central banks painting themselves into a corner or losing control or accidentally causing a disaster is not true. It is done with good reason. The reason is, in the current case, smoothing out the aftermath of Covid. Printing money as any stimulus check receiver should agree or company that got a Covid bailout loan forgiven should understand, is not a bad thing to get a bail out, when the alternative is going bust. The bill is the inflation that follows. Now people do not want to pay that bill, but here it is. To me it’s not such a high price when the alternative was an economic meltdown.

So what next for inflation?

Firstly the Covid inflation surge is going to wash out, now the Federal Reserve has stopped printing more money. Europe’s inflation will do the same thing once it does the same in 2022. No new money will mean the pipeline of inflation filled by the QE of the pandemic will empty and the rate of the rise of inflation will halt shortly and the headline rate will drift down. If you do not create more new money than real growth, then there is no inflation to be had, in fact, technology should cause deflationary pressure.

The bad news, and I find it almost unbelievable, is that the US is looking at a $1.5 trillion a year deficit on average over the next ten years. I’d think this to be fake news if it wasn’t on the congressional budget site.

Over the next three years it’s about $1 trillion a year. So if there was to be zero growth, the US is in for a 5% of GDP deficit. That money needs to come from somewhere and that will likely be the printing press.

So if the 2020-2021 deficit was say $4tr over what might have been norm and created a 6% surge in inflation, then the drum beat of trillion dollar deficits is going to set the U.S. up for 4%-5% inflation going forwards, which seems about the sort of level you would set to wash the lumpy losses of the pandemic out of the system. These are all napkin calculations, but it all leads to a call on markets.

This trillion dollars a year need is going to fuel inflation, and if the Federal Reserve is going to get this money from borrowing from outsiders while shrinking the money supply, it will have to get rates pretty high which will toss the U.S. into recession making the real value of the deficit go up and servicing costs mushroom and the deficit itself balloon. It will also do horrible things like crush the value of its bonds, which is hardly something you want to do if you are going to issue more bonds. Instead it will tack and trim, printing enough new money to try and keep the economy growing at a 2-3% rate, with elevated inflation running at above creeping inflation but below runaway inflation, which is likely back to the 4-5% level and it will talk tough to try to manage inflation expectations.

Right now this is the trajectory:

If the above assumptions are correct, this chart will not show much of a fall in the coming months and years. It will do what it did between 2014-2018, hold the line and let nature take its course so long as that course is sideways or up for the economy. The market will go as the economy will go, which is nowhere in particular until the damage of the pandemic is behind the economy.

How long is that? 18 months to two years.

When the volatility drains out of the market you will know it’s safe again, but until then there will be plenty of moments this balancing act could go wrong. If the dollar continues its rampage then all bets are off.