The Fed's Ticking Inflation Bomb

The Fed's Ticking Inflation Bomb

Peter Ferrara

Peter Ferrara is senior fellow for entitlement and budget policy at The Heartland Institute, a... (read full bio)

Larry Kudlow, as usual, said it best. Writing in Investor's Business Daily on September 14, he said:

About 30 years ago, Paul Volcker launched a monumental monetary effort to bring down inflation. As Fed Chairman, he sold bonds, removed cash from the economy, and cared not one whit about rising interest rates.
 And it worked. Gold plunged. King Dollar soared, and the drop-off in bank reserves and money extinguished high inflation -- and actually launched a multi-decade period of very high inflation."
 
This week, current Fed Chairman Ben Bernanke embarked on an absolute reversal of Volcker's policy. He is launching a monumental effort to buy bonds and inject new money into the economy in order to reignite economic growth and job creation.
 
It is like history repeating itself, but in reverse. Gold is soaring, the dollar is falling. Something's wrong with this picture.
 
QE3
 Kudlow is talking about the Fed's new policy of QE3, announced last Thursday. Under QE3, the Fed will buy $40 billion of additional mortgage securities each month with money it prints out of thin air. QE stands for "quantitative easing," which means in English printing new money. It is called QE3 because this is the third time the Fed has pursued a policy of aggressive new money creation since the financial crisis.
 
But as the Wall Street Journal editorialized on Friday, "the difference this time is that Ben [Fed Chairman Bernanke] is unbounded." By that they mean that the Fed's policy is to continue the $40 billion a month magic money creation until the job market improves and the recovery takes hold. Or as the Journal further editorialized, "The Fed has declared that it is going all in to cut the jobless rate, no matter what it takes."
 
That echoes the recent announcement of the European Central Bank (ECB) that it will pump up the supply of euros there to "whatever it takes" to forestall the European sovereign debt crisis. What we are witnessing is a global trashing of major paper currencies.
 
The Fed is effectively in a panic now because it knows what the party controlled so-called mainstream press is so carefully keeping from the voters in swing states -- real, effective, unemployment is much worse than 8.1%, somewhere between 11.4% and 19% depending on how many of the disoriented, working-age Americans bouncing around out there without a real job are counted in the workforce. And that double-digit unemployment has now continued for the longest time since the Great Depression, with no relief in sight.
 
Under the Fed's QE policies, the Fed's balance sheet of its asset holdings has tripled from about $800 billion to $2.5 trillion. With QE3, that will now "go to $3 trillion, or $4 trillion, or who knows how high?" Kudlow says. Moreover, bank reserve balances at the Fed, created out of thin air by Fed electronic deposits, have exploded from $8 billion in September 2008 to $1.5 trillion today, an increase of almost 200 times.
 
And make no mistake about, this Fed policy is Obama Administration policy, backed by the Administration and the President himself.
 
It Won't Work
 The idea behind quantitative easing is that the new money will increase spending, investment, exports, and consequently jobs, resulting in the long overdue recovery at last. The new money will also support the Fed's rock bottom interest rates, which is also supposed to spur investment, the foundation for job creation.
 
It's standard Keynesian monetary economics. But it won't work. Quite to the contrary, it will be counterproductive. With the collapse of communism, Keynesian economics is now the second most destructive doctrine in the world, right behind Islamism.
 
Printing up new dollars and dropping them from helicopters is not going to make America any richer or more prosperous. That is all that QE is. It doesn't mean any increased real wealth, income, or production. You can't trick the real economy into producing more just by running the printing presses.
 
The new money supply just ends up increasing prices, as there is more money out there bidding for the available real goods and services, which are not increased by money manipulation. That is what Milton Friedman finally prevailed in teaching over 30 years ago. But in this new Obama/MSNBC world, civilization is hurtling backwards, losing learning and advancement, just like Europe after the collapse of the Roman Empire. The only question is how long it will take for market prices to catch up to the new money supply. That short-term period can be extended by economic downturn and recession. But as the 1970s showed, Keynesian economics can produce the miracle of inflation and recession at the same time.
 
Indeed, the Fed has been purchasing three-fourths of the new federal debt issued to cover Obama's trillion dollar deficits, with the new money printed up in accordance with QE. This is a classic, historic policy for creating inflation, and ultimately national bankruptcy if continued.
 
Moreover, higher prices and inflation mean that real income, after inflation, declines. Lower real income means less spending, not more. But spending is not what drives economic growth and prosperity anyway. Just as you cannot spend yourself rich, neither can the economy as a whole. What drives economic growth is incentives for increased production, and the productive activities that produce it, such as saving, investment, starting businesses, expanding businesses, job creation, entrepreneurship, and work. But incentives don't compute in Keynesian economics. That is too much capitalism, and "Keynesianism," just like the broader term "Progressivism," is just another, polite, Americanized term for Marxism.
 
Moreover, that inflation, and even before that the expectation of inflation when the loose money (QE) begins, translates into a declining dollar. That declining dollar means less investment, not more, because investors do not want to be paid back in depreciated dollars. The lower interest rates also mean less investment, and less savings, not more, as the returns to savers as well as to investors decline. Less savings means there must be less investment, not more, because there is less savings to invest.
 
But less investment means fewer jobs, and less demand for labor, which means lower wages and incomes, even before inflation reduces real wages and incomes further. Isn't that what we just heard from Census last week, that real median family income has declined precipitously under Obama?
 
As Kudlow again explains it, with careful understatement:

More money doesn't necessarily mean more growth. More Fed money won't increase after-tax rewards for risk, entrepreneurship, business hiring, and hard work. Keeping more of what you earn after-tax is the true spark or economic growth. Not the Fed.
 
In the supply-side model, the combination of lower marginal tax rates, lighter regulation, and a downsized government in relation to the economy is the growth-igniter. Money, on the other hand, determines the value of the dollar exchange rate and subsequently the overall inflation rate. A falling dollar (1970s) generates higher inflation, a rising dollar (1980s and beyond) generates lower inflation.
 
This is the supply side model as advanced by Nobelist Robert Mundell and his colleague Arthur Laffer. In summary, easier taxes and tighter money are the optimal growth solution. But what we have now are higher taxes and easier money. A bad combination.
 
Indeed, the Wall Street Journal further editorialized on Friday why QE3 will actually be counterproductive:

QE2 succeeded in lifting stocks for a time, but it also lifted other asset prices, notably commodities and oil. The Fed's QE2 goal was to conjure what economists call 'wealth effects,' or a greater propensity to spend and invest as consumers and businesses see the value of their stock holdings rise. But the simultaneous increase in commodity prices lifted food and energy prices, which raised costs for businesses and made consumers feel poorer. These 'income effects' countered Mr. Bernanke's wealth effects, and the proof is that the economy decelerated in 2011. It decelerated again this year amid Operation Twist [still more loose monetary policy].
 
So QE3 is not going to bring down unemployment and stimulate the long overdue recovery. It is going to further stall recovery and job creation and growth, leaving unemployment over 8% even longer.
 
The Coming Crash of 2013
 But it is all much more worse than this. What the Fed has done with its now extended QE is prime a ticking inflation bomb that absent fundamental monetary policy reform will explode to cause the next recession. Indeed, combined with Obama's enormously recessionary, comprehensive tax rate increases going into effect January 1, and his galloping regulatory cost increases scheduled to accelerate further next year, the result is going to be renewed, double-dip recession, before we have even recovered from the last one. That is how in the end instead of saving us from depression, Obama is creating one.
 
All of the runaway money creation from the Fed's QEs is now sitting out there threatening to cause booming inflation as soon as the economy begins to recover. Bernanke has said from the beginning not to worry, however, because he will ride to the rescue and pull that money back out at just the right time.
 
But withdrawing that money from the economy will be contractionary. That will be accompanied, moreover, with soaring interest rates from their current rock bottom level, which has now prevailed for years, and is deeply woven into economic decisions, investments and ongoing businesses. Those soaring interest rates will further contribute to recession and decline.
 
The Fed will face irresistible pressure from the politicians in Washington, the banks in New York, and business and labor across the rest of the country, to avoid that painful medicine, until inflation becomes so bad that there is no alternative. That will be complicated all the more by the Fed's commitment to zero interest rates well into 2015. That commitment will further restrict the Fed from taking timely action to preempt the looming QE inflation.
 
But once the Fed let's the inflation bomb explode, restoring the double digit inflation of the 1970s, it will take still another recession to stop it, just like the 1982 recession resulted from Volcker's strict medicine to kill the double digit inflation of the 1970s. When the economy turns down into another recession like 1982 or worse after this monster recession, the entire extended period will seem like an historical reenactment of the 1930s, except this time people's incomes and savings will be further ravaged by inflation.
 
Restoring the American Dream
 At the Democratic National Convention, President Obama regaled the nation with this misleading fallacy, among so many others:

I won't pretend the path I am offering is quick or easy. I never have. You didn't elect me to tell you what you wanted to hear. You elected me to tell you the truth. And the truth is, it will take more than a few years for us to solve challenges that have built up over decades.
 
But the truth is that with the right economic policies, the long overdue recovery will break out into a boom in less than a year, almost immediately in fact, just as the Reagan recovery took off once his Kemp-Roth tax rate cuts took effect. Those policies involve just the opposite of everything that Obama is doing. Tax rate cuts instead of increases, as Romney has proposed. Lower regulatory burdens rather than more, including unleashed, maximized energy production, as Romney/Ryan have proposed. Restored control over federal spending, deficits and debt, as the Ryan budget proposes.
 
The critical missing link in the Romney/Ryan economic program is monetary policy, where they have left a blank slate. But the current monetary turmoil would be quickly resolved if the Fed was leashed to follow a price rule in monetary policy, tying its policies to the most policy sensitive commodity prices, such as oil, silver, copper and other precious metals, but most especially gold, the most policy sensitive commodity of all given its ancient tradition as a store of value and money in itself.
 
Under a price rule guiding monetary policy, when such prices start to rise in markets, that would signal the threat of inflation is rising, and the Fed should tighten monetary policy and the money supply. When such sensitive prices start to fall, that signals the threat of recession or even deflation, and the Fed should ease monetary policy. Following such monetary policies would avoid inflation and deflation, and cyclical bubbles and recessions, and maintain a stable value of the dollar. That promotes investment, jobs and economic growth because investors know the value of their investments will be maintained without depreciation due to inflation or a declining value of the dollar, and cyclical recessions that might crash their investments will be minimized.
 
When America is liberated from Obama's Marxists, such measures will quickly restore booming American prosperity, and the American Dream.

Peter Ferrara

Peter Ferrara is senior fellow for entitlement and budget policy at The Heartland Institute, a... (read full bio)