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The vast majority of
economists now say that the recession is over. Many expect nominal GDP growth
as high as four percent in 2010. Now, with the economy assumed to be back on
stable footing, some in the private sector are starting to talk about
inflation.
While agreeing that
growth has returned, the Federal Reserve and the Obama administration do not
see inflation as a threat. To them, the political costs of ongoing recession
far outweigh any medium-term considerations about the value of the dollar,
hence their determination to hold short-term interest rates to around zero. This
has created unnatural conditions in the U.S. Treasury market and is limiting
the prospects for real growth.
The Fed lending at
zero enables the major banks to invest in long-term Treasuries at a huge
risk-free spread of nearly four percent. In addition, the Fed is - for the
first time - paying interest on bank reserves deposited with the Fed. In such
a 'la-la' world, why would any bank take the needless risk of lending to
small businesses, the main creators of new jobs? For all but the largest
corporations, who can also access the bond markets directly, credit is tight.
The lack of private-sector bank liquidity has hurt job creation, consumer
demand, and is adding mightily to recessionary pressures.
What's worse, this
monetary treadmill has disrupted market signals about coming inflation.
When the vast sums
lent to the banks are recycled back to the government, the money remains
exclusively a part of the monetary base, but never enters the money supply. Only
when the banks are induced to lend to the real economy does the 'rescue'
money flood into the market and drive up consumer prices.
Currently, inflation
appears low. But if the Fed decides to raise interest rates, the risk-free
trade between the short end and long end of the yield curve will be
eliminated. At that point, banks will have to start lending to small business
and to individuals. The whole inflation picture will be changed dramatically.
More importantly,
what if Bernanke is not fully in control of interest rates? For instance, as
investors grow wary of growing federal deficits, the potential for high
inflation, and the looming probability that the Fed will raise rates, they
may exert selling pressure, particularly at the long end of the yield curve. Indeed,
with some four percent yield differential between short and long Treasuries,
the curve is steeper than it has been for years. This selling pressure could
force Bernanke to raise short-term rates.
Evidence of
increasing inflation could also drive Bernanke to raise interest rates before
he plans to do so. If the Fed is compelled follow such a course, several
things are likely to occur.
First, there would
be a rapid sell-off in overpriced long-dated Treasuries. This would be the
'bond market crash' that we have long envisaged.
Second, American
equities will likely experience downward pressure as the discount rate, used
to assess the present value of dividends, rises.
Third, a rise in
interest rates could trigger a crisis in interest rate-dependent derivatives
held by banks, similar to circumstances of the last credit crisis.
Finally, and most
concerning, higher rates would increase the debt burden for the U.S. government, which is increasingly sold in short-term notes. With a stagnating economy,
the tax base will be unable to shoulder this extra weight. This could
potentially lead to the largest sovereign default in history.
Many commentators
are arguing that hyperinflation cannot happen in the midst of a second credit
crisis. In fact, hyperinflation tends to happen in rapidly contracting
economies: Zimbabwe, Weimar Germany, Argentina. These countries have negative
productivity growth and thus cannot 'soak up' the excess currency being
printed to keep prices stable.
Based on his
perceived diagnosis of the Great Depression, Bernanke is betting the house on
his War on Recession. Despite the media's faith that he has an ace up his
sleeve, it is a foolhardy gamble with the country's economic future.
John Browne
Senior
Market Strategist
Euro Pacific
Capital, Inc.
20271 Acacia
Street, #200 Newport Beach, CA 92660
Toll-free:
888-377-3722 / Direct: 203-972-9300 Fax: 949-863-7100
www.europac.net
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John Browne is the
Senior Market Strategist for Euro Pacific Capital, Inc. Mr. Brown is a
distinguished former member of Britain's Parliament who served on the
Treasury Select Committee, as Chairman of the Conservative Small Business
Committee, and as a close associate of then-Prime Minister Margaret Thatcher.
Among his many notable assignments, John served as a principal advisor to
Mrs. Thatcher's government on issues related to the Soviet Union, and was the
first to convince Thatcher of the growing stature of then Agriculture
Minister Mikhail Gorbachev. As a partial result of Brown's advocacy, Thatcher
famously pronounced that Gorbachev was a man the West "could do business
with." A graduate of the Royal Military Academy Sandhurst, Britain's
version of West Point and retired British army major, John served as a pilot,
parachutist, and communications specialist in the elite Grenadiers of the
Royal Guard.
In addition to careers
in British politics and the military, John has a significant background,
spanning some 37 years, in finance and business. After graduating from the Harvard Business School, John joined the New York firm of Morgan Stanley & Co as an
investment banker. He has also worked with such firms as Barclays Bank and
Citigroup. During his career he has served on the boards of numerous banks
and international corporations, with a special interest in venture capital.
He is a frequent guest on CNBC's Kudlow & Co. and the former editor of
NewsMax Media's Financial Intelligence Report and Moneynews.com. He holds
FINRA series 7 & 63 licenses.
Copyright © 2008
Euro Pacific
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