Inflation With a Slowing Economy

Everything was down hard this week. Of course, sandwiched between down days was a face ripping short covering rally that served to whiplash your editor in and out and then back in to taking a modest short position (SH-NYSE Proshares short S&P). Like Pavlov’s dog, the market has been conditioned to think the Fed will come to our rescue when any bell rings for the next Fed Put, first introduced by Fed Chairman Greenspan in 1987 and then implemented by all Fed chairmen since, including Jay Powell until serious inflation reared its ugly head. 

What triggered the chaos in the market this week was a hotter-than-expected CPI and a hotter-than-expected core inflation rate that hit the highest levels in 40 years! Headline CPI rose 0.4% MoM (double expectations) and up 8.2% YoY (hotter than the +8.1% exp). Core CPI is up 28 straight months, soaring to +6.6% YoY—the highest since August 1982. The PPI is a measure of prices at the production phase of goods and services, and is often an indicator of where consumer prices are headed. Prior to 1978, the index was known as the Wholesale Price Index.

Keynesians can’t figure out why we have inflation at the same time rates are rising and the economy is slowing. They have always believed that the supply side of the economy was unimportant or that it would always take care of itself or, if it didn’t, governments could do the job. Do you remember when Hillary Clinton said, “It’s governments that create wealth, not the private sector.” They believed that whenever an economy slowed, monetary and fiscal stimulus can always be used to return to economic growth. They have always ignored the pernicious anti-growth impact of massive sovereign and private debt relative to GDP. But as former Federal Reserve economist Lacy Hunt has documented, once federal debt/GDP climbs above ~60%, monetary policy becomes impotent. The U.S. debt/GDP is now around 130% compared to just 35% when Paul Volcker stopped double digit 1970s inflation in its track with dramatically higher rates starting in 1980. But, the 1970s weren’t anything like the derivative liabilities we on our books today. Most importantly, the Keynesians have destroyed capitalism by refusing price recognition of capital. Constant monetary stimulus with every significant dip in the stock market earned Alan Greenspan plenty of praise from inebriated partygoers on Wall Street and in Washington. The Queen even knighted him!  But, now after the Financial Crisis and COVID, we have a debt/GDP rate of ~130%. At these levels the math doesn’t work, and thanks to the Fed’s manipulation of interest rates, we have more mal investment for our size than John Law had with his Mississippi Bubble before it imploded. Alasdair Macleod pointed out on my show in the past that the Fed was enacting exactly the same policies as John Law’s national French bank did—namely, print massive amounts at a faster and faster rate of speed in an attempt to keep the Mississippi Company stock from heading into bankruptcy. At least until recently when the Fed belatedly realized inflation was a serious problem it had been printing more and more money at a faster and faster rate of speed to keeps U.S. Treasuries and stock prices overvalued and secondarily to keep the U.S. economy from imploding over an ever-growing burden of debt.

An understanding of how the real-world works has been outlined by the Austrian economists. For starters, they understand the importance of market driven, asset-based money in the form of silver or gold in preserving a free-market economy with an even playing field for fair free market competition that rewards achievement and teaches lessons to market participants when they fail.  

But now, even most of the major central banks have negative net worth because of all the debt they purchased at low interest rates to try to keep bond prices elevated and interest rates low. Finally, the Fed now seems to understand it is in real trouble and that hyperinflation could destroy the dollar. Chairman Powell knows the only way he can avoid the total destruction of the dollar and the dollar based monetary system is by allowing interest rates to find their true market equilibrium, as Volcker did in the 1970s. But again, given America’s 130% debt to GDP, Powell’s task is infinitely more difficult than Volcker’s was in the 1970s. And it was very difficult!  I was in my early 30’s in those days and I remember how frightening it was to take on a 17.5% mortgage as inflation appeared to be going hyper and energy related geopolitical strife seemed to be leading us toward destruction. When Volcker stopped monetary growth in 1980, it led to the deepest recession since the Great Depression at that time. Unfortunately, Fed chairmen since him, starting with Alan Greenspan, took the politically easy way out by kicking the can down the road. Now that we have run out of road on which to kick the can, we are at that point in time when there is no easy way out. The Fed must choose either hyperinflation to keep debt and equity instruments falsely priced at artificially high levels that are no longer mathematically viable or let interest rates find their equilibrium levels, in which case the global economy, which is intoxicated with lethal levels of monetary narcotic, is forced to “sober up” and let the economic system be restored to health and prosperity once again through a devastating depression.

In Alasdair Macleod’s latest weekly essay, titled, Baking Crisis—the Great Unwind, which you can read on the research page at www.GoldMoney.com, in his concluding remarks he explains the very hard choice the Fed is facing. He puts to one side all the economic concerns of a downturn in the quantities of bank credit in circulation and focuses on the financial consequences of a new long-term trend of rising interest rates. Alasdair says that it should be coming clear that they (banks) threaten to undermine the entire fiat currency financial system that may (hopefully) give way to a return to non-fiat monetary system. Here is how Alasdair concluded his Oct. 13 essay: 

“Credit Suisse’s public problems should be considered in this context. That they have not arisen before was due to the successful suppression of interest rates and bond yields, while the quantities of currency and bank credit have expanded substantially without apparent ill effects. Those ill effects are now impacting financial markets by undermining the purchasing power of all fiat currencies at an accelerating rate. 

“From being completely in control of interest rates and fixed interest markets, central banks are now struggling in a losing battle to retain that control from the consequences of their earlier credit expansion. That enemy of every state, the market, has central banks on the run, uncertain as to whether their currencies should be protected (this is the Fed’s current decision and probably a dithering BOE) or a precarious financial system must be the priority (this is the ECB and BOJ’s current position). 

“But one thing is clear: with CPI measures rising at a 10% clip, interest rates and bond yields will continue to rise until something breaks. So far, commercial banks are dumping financial assets to deleverage their balance sheets. The effects on listed securities are in plain sight. What is less appreciated, at least before LDI schemes threatened to collapse the UK’s gilt market, is that the $600 trillion OTC derivative market, which grew on the back of a long-term trend of declining interest rates, is now set to shrink as contracts go sour and banks refuse to novate them. That means that up to $600 trillion of notional credit is set to vanish, in what we might call the Great Unwind. 

“This downturn in the cycle of bank credit boom and bust will prove difficult enough for the central banks to manage. But they themselves have balance sheet issues, which can only be resolved, one way or another, by the rapid expansion of base money. And those risks undermine all public credibility in fiat currencies.” 

How will all this game of chicken that the Fed is playing play out? As Alasdair points out, the Fed is so far at least opting to save the currency by allowing interest rates to rise toward their honest market rates. On the other hand, Japan and Europe are opting for currency destruction path that the French central bank took in maintaining the stock price of the Mississippi Company even as it became increasingly obvious that its currency was becoming intrinsically worthless. It could very well be that the scenario that James Rickards laid out on my radio show years ago will be the ultimate outcome. His view was then that with all the central banks themselves becoming insolvent, a new monetary reset would evolve with the IMF issuing SDRs. In the meantime, Russia and China are progressing toward a monetary system backed by commodities that provide intrinsic value to their evolving currency. Alasdair’s view on that is that ultimately the commodities that back that new currency will be priced in grams of gold, which should be very bullish, one should think, for gold as it replaces a currency that has lost its value, like the U.S. dollar that is intrinsically worthless.

About Jay Taylor

Jay Taylor is editor of J Taylor's Gold, Energy & Tech Stocks newsletter. His interest in the role gold has played in U.S. monetary history led him to research gold and into analyzing and investing in junior gold shares. Currently he also hosts his own one-hour weekly radio show Turning Hard Times Into Good Times,” which features high profile guests who discuss leading economic issues of our day. The show also discusses investment opportunities primarily in the precious metals mining sector. He has been a guest on CNBC, Fox, Bloomberg and BNN and many mining conferences.