While I am a long-term optimist, I am quite pessimistic in the short run. It is not that I want to be pessimistic. It is just that I am a realist and I can only conclude that there are some rough times ahead. I’m not sure if it will become evident this year, next year, or a few years from now. I can’t imagine that 5 years from now we will have avoided economic turmoil much worse than what we have now.
I like to look at the adjusted monetary base and the excess reserves held by commercial banks. It gives us a good picture of what the Fed is doing (massive monetary inflation) and what the banks are doing with the vast new money being created (not lending it out). The monetary base indicates that we should have massive price inflation, but the huge increase in excess reserves indicates just the opposite.
But these are not the 2 statistics that I am referring to in this post. I think 2 statistics that can give us a good warning shot are the Consumer Price Index (CPI) and the 10-year yield on U.S. treasuries.
I understand that many people do not like the CPI. It is a government measure and its calculation has been changed in the past. I agree that it does not give us a really accurate measure of price inflation. However, I do think it gives us a good enough picture of the trend of consumer prices. And if consumer prices are rising, then the Fed may worry that it has to stop its monetary inflation.
The 10-year yield is important in a lot of ways. If interest rates rise, then the government will have to pay higher interest for newly issued government debt. In addition, mortgage rates are highly correlated with the 10-year yield. A third possible factor is that the value of the Fed’s holdings will actually go down as interest rates rise.
And to tie the two statistics together, if the CPI starts rising rapidly, then this could cause interest rates to rise rapidly. There is not much of an inflation premium for U.S. bonds right now, but this will change if investors perceive rising prices as a major threat.
It is hard to say what the Fed will do in such a situation of a rising CPI and rising rates. It has not had to worry too much about this yet. But if it does happen, it will have to decide whether to keep the monetary inflation going and risk even higher price inflation or to stop the monetary inflation and risk a depression.
Either way, there is going to be trouble ahead. It is not that I want it to happen or that I think it will happen because of future policies. It is already baked into the cake. We cannot avoid the consequences of previous bad policies. We can try to minimize the damage by getting policies right going forward, which would include ending monetary inflation and massively cutting government spending.
The Fed is happy right now. It is getting a free ride in a way. It is creating huge monetary inflation, bailing out the banks, and we have had relatively low consumer price inflation. This cannot last forever. The pain can only be delayed for so long. So when you see the CPI rise significantly and you see rising rates with it, then that is your warning that you should hunker down and get ready for some rough weather ahead.