Robert Murphy has written another great article, this time on the Fed and quantitative easing.  In the latter half of the article, he describes a black swan scenario where price inflation all of a sudden gets out of hand. I want to focus on one particular part of his article.  It is something that I’ve written about before.

Towards the end of the article, Murphy states,
“The problem is that Bernanke is sitting on huge piles of US government debt, which have just gotten decimated in the bond market. For example, if Bernanke in 2010 had created $1 billion of new reserves by buying $1 billion in additional Treasury debt, those securities would now be worth (say) only $650 million. So even if Bernanke sells them all back into private hands, he will only be able to eliminate 65 percent of the new reserves he had earlier created. Open market operations will not allow him to drain the system.”


This is what I discussed in the past with mortgage backed securities.  If the Fed bought all of these mortgage backed securities back in 2008 to bail out the banks and the Fed paid the original value of these things, what happens when the Fed tries to sell them?  After all, a lot of these mortgages have gone bad.  We hear about the horrible housing market and all of the short sales and foreclosures.  So let’s say that all of these mortgage backed securities are only worth half of what the Fed actually paid for them.  If high price inflation becomes a problem and the Fed tries to sell these assets, they will only be able to sell them for half of what they paid.


Just for example, let’s say the Fed paid $1 trillion for mortgage backed securities.  Now the Fed sells these and can only get half or $500 billion for them.  What happened to the other $500 billion?  That money is already in the system.  The Fed can’t soak it up.  It has no exit plan.  All it can do at that point is prevent future monetary inflation.


The only other possibility is forcing the banks to buy them back for the original value.  But why would the Fed do this when one of its main unstated purposes is to prop up banks?  Also, this would severely weaken the banks and could cause banks to fail.  Then the FDIC would have to bail out depositors and the Fed would have to bail out the FDIC.  This would defeat the original purpose of trying to soak up the excess money in the system.  Therefore, this is an unlikely scenario.


I don’t think the Fed would intentionally cause hyperinflation.  The bankers would be destroying themselves.  The fear that I do have is that they somewhat unintentionally destroy the dollar.  They think they can pull back at any time, just as Volcker did in the late 70’s and early 80’s.  But based on the discussion above, it may be impossible for the Fed to soak up all of the excess money once price inflation becomes bad.  If Bernanke and the Fed really do have an exit strategy, I sure would like to hear what it is.

George W. Bush has been back in the news lately with the release of his book.  He basically admits to allowing torture and he is as arrogant as ever.  He is also as incoherent as he has ever been.  The guy can’t admit any mistakes and of course he still thinks he made the right decision in invading and occupying Iraq.

This is something that ruffles a lot of feathers, but Bush and Obama are a lot more alike than most would care to admit.  They are both arrogant and full of themselves.  They both surround themselves with horrible people.  Can you think of two more sleazy people than Karl Rove and Rahm Emmanuel?  These people are pretty much the scum of the earth.  This only shows that Hayek was correct in his assessment that the worst rise to the top in politics.  The presidency is the top and we continue to see the worst.

Ultimately, politics is not our answer to having a more free society.  The game has been rigged for a long time.  The Republicans and Democrats are in on it together.  There was not much of a choice between Bush and Kerry or between Obama and McCain.  Either way, we get an establishment politician that will continue with more war and more welfare.

If you want to help in bringing a more liberty-oriented society, the best thing you can do is to educate yourself and educate others.  Many libertarians neglect the first part.  They are not well versed in libertarianism.  How can you educate others on the benefits of liberty if you yourself cannot explain your position to others?  We should all seek to better ourselves at all times and we should always work on making our position more understandable for others.

We don’t need to elect a libertarian to the presidency to move in a libertarian direction.  You should remember this when investing too.  We could have a total socialist in office, but it doesn’t mean that you should move out of the country or bet on a horrible economy for the rest of your life.  A libertarian revolution could be happening right under your nose, but you just don’t see it because you are watching the mainstream media talking heads and looking at the fools in Washington DC.  We should not underestimate how much the politicians can wreck the economy, but we also shouldn’t underestimate how much the free market can overcome.

Bonds are an interesting investment right now.  There is definitely a tug of war going on, particularly with U.S. government bonds.  On the one hand, bonds should be doing poorly with interest rates rising because of all of the money printing.  Bond buyers should be asking for higher rates to compensate the risk of inflation.  On the other hand, bonds should being doing well (which they generally have been) because the Fed is buying them.  Who wants to compete against the Federal Reserve, with the deepest pockets in the world?  If the Fed announced that it would be buying shares of Microsoft, I would expect the stock price of Microsoft to skyrocket.

The relationship of interest rates and inflation can be a bit confusing.  It is like wondering if someone wearing a jacket is hot or cold.  He might be wearing a jacket because he’s cold or he might be hot because he’s wearing a jacket.  The cause and effect are not always clear.  It is much the same with interest rates and inflation.

Ultimately, artificially low interest rates and money printing usually translate into price inflation.  But even that is not a guarantee.  Japan has had low rates for a couple of decades with little price inflation (although it hasn’t really been deflationary as many will claim).

There is no doubt that the Fed’s policy is inflationary and will probably translate into higher prices in the future.  Unless Helicopter Ben isn’t really who he says he is, then I would expect the money creation to continue as long as there is high unemployment with a weak economy.  I think the only way he will pull back is if there is a threat of really massive inflation.

In the long run, shorting bonds will probably be a good speculation.  It is a speculation though because nothing is a sure thing and we also don’t know the timing of it.  I would not short bonds in the next 6 months.  Bernanke and the Fed will be implementing QE2, which means they will be buying government bonds.  I would not compete against them.  There is no guarantee that their purchases will drive down rates as intended, but I also wouldn’t fight it.  We should look for higher price inflation before we start considering a short play.

When it is time, there are easy ways to bet against bonds.  If you aren’t into options, you can purchase a double inverse ETF of longer term government bonds (symbol: TBT).  As interest rates go up, the fund will also go up.

Again, it might be an interesting speculative play in the future, but I would be patient and not bet against the Fed right now.

Robert Murphy has an article on the Mises Institute website today called Currency Wars.  Murphy is one of the best, if not the best, economists that I know of.  He understands Austrian economics as well as anyone (he wrote a study guide for Human Action), but he also knows how to write and speak in language that almost anyone can understand.

He correctly points out that when a government/central bank inflates its currency, it can have a beneficial effect for exporters of that country.  Of course, as good economists, we have to look at the unseen consequences and see that it makes things more expensive for everyone.

Since Bernanke announced QE2, there has been criticism from foreign governments.  Some, like China, should be concerned because of the large amount of U.S. bonds that the country owns.  The more the Fed inflates, the more worthless the bonds will become.  The problem is, many foreign governments are criticizing Fed policy because they think they too will have to engage in inflation.  It is because they say it will hurt their exporting business.

Once again, these foreign politicians are not looking at the benefits of Fed inflation.  It’s true that it may hurt exporters in their country, but it will also help importers with cheaper goods.  Whether the Fed’s policy hurts or helps another countries citizens on net, it doesn’t mean the other countries should partake in the same destructive policy.  They will only be further hurting their own citizens by making things more expensive and misallocating resources.

This whole subject reminds me of the discussions about Japan in the past.  People would be in a panic because Japan (although it wasn’t literally the country but mostly private businesses) was selling cheap cars and electronics to Americans.  They thought if the Japanese government subsidized this at all, that it was hurting the U.S.  They never stopped to think that the Japanese government was subsidizing Americans at the expense of Japanese citizens.

My response was that if the Japanese (government or companies) started giving away free televisions and cars to Americans, would this be bad for Americans?  I’ll take inexpensive products all day long.  Better yet, I’ll take them free if someone else wants to build them and transport them to me without accepting payment.

Ignorance in economics runs rampant throughout the world.  It is hard to believe, but Americans are actually better educated in economics than the average person elsewhere.  This is a generalization of course, but just look at the situations in other countries.  You don’t see tea parties in most other places or at least not on the scale you see in the U.S.  There are Keynesians throughout the world and it seems that the U.S. is actually the best hope sometimes.

The U.S. government is the biggest empire ever and the Fed is doing horrible things, but I’ll still place my bets on the American people.  More people are becoming educated in economics and monetary policy, especially with the internet.  The Fed will cause a lot of problems in the near future, beyond what has already happened, but its days may be numbered.

Velocity, or demand for money, is a topic that is not understood real well.  When it comes to price inflation, the focus tends to be on the money supply.  While the money supply is extremely important and it has an effect on velocity, it is really only one half of the equation.

Velocity is the speed at which money changes hands.  It is also called the demand for money.  If the demand for money is high, then people are holding onto their money and spending less.  Another way of saying this is that the velocity is low.  Money is changing hands at a slow pace.  If people are spending money and it is changing hands quickly, then velocity is high and the demand for money is low.

After the fall of 2008, velocity slowed down.  People spent less money, paid down debt, and were cautious with their money because of fear of unemployment and a bad economy.

If there is an increase in the supply of money, this should raise the general price level.  If velocity slows down, this has a counter effect.  Low velocity is deflationary on prices.  The opposite is also true.  An increase in velocity acts as an inflationary effect on prices.

This is important to understand because prices will not always move with the money supply.  The money supply could increase and yet we might not see prices rise because people are scared and holding onto their money.  You can have more money in the system, but prices won’t rise unless people are using the money to bid up prices.

By the same token, price inflation could also increase faster than monetary inflation.  That is a real threat that we have to worry about.  The Fed will not intentionally cause hyperinflation.  The Fed members and other bankers would essentially be destroying their own game.  Hyperinflation would be bad for almost everyone, including bankers and politicians.  The threat though is that the Fed tries to produce mild price inflation, as it is trying now, but gets carried away and can’t stop the massive price inflation.  The Fed could slam on the monetary brakes, but if the general public views the U.S. dollar as risky to hold onto, then velocity could go up very quickly.  People might start spending money like crazy, knowing that it will be worth less every day that it is held.

If the general public thinks that the Fed will not stop and that high inflation will continue, then a hyperinflation of prices could occur.  This is not a prediction as I think the Fed will pull back eventually and the general public will realize it and we will have a deep recession or depression.  But it is good to know what it possible and runaway price inflation is possible because of velocity.  It all depends upon the attitudes of those holding the currency (which also includes foreigners).  So while we should pay close attention to the money supply and bank reserves, we should also pay attention to the views of the market and whether people are spending their money in fear of future inflation.

Velocity is almost impossible to measure, but we should at least try to get a sense of what the general thoughts and attitudes are of those holding U.S. dollars.

It will be important over the next 8 months to watch the monetary base and the excess reserves held by commercial banks.  Although there are other factors, these two charts will give us a good idea of how much new money is being injected into the economy.  The more money that enters, the higher prices will go.

Again, this isn’t the only factor.  Velocity, or the demand for money, plays a huge role (more on that in the future), but the supply of new dollars in the economy will have a major impact on consumer prices.

We need to watch what Bernanke and the Fed do, not just what they say.

For the adjusted monetary base, go here:
http://research.stlouisfed.org/publications/usfd/page3.pdf

For the excess reserves, go here:
http://research.stlouisfed.org/fred2/graph/?chart_type=line&s[1][id]=EXCRESNS&s[1][range]=1yr

Charles Goyette is the author of the lead story on LewRockwell.com today.  Goyette is the author of a great book called The Dollar Meltdown.  If I had to advise someone on what to do with their money, I would tell them to put a large portion, say 80%, in a permanent portfolio as outlined by Harry Browne in his book Fail Safe Investing.  With the remainder of your money, put it in the investments recommended by Goyette in his book.

Now let’s talk some more about QE2.  The Fed is planning to buy $600 billion worth of bonds over the next 8 months, plus up to another $300 billion that it collects from its current assets.  We can forget about the $300 billion because it is really neutral as far as the money supply.  It is the $600 billion we need to focus on.

Does this new money run up the national debt?  No, not directly.  If the Fed didn’t create this new money, would the debt go down?  No, at least not in the short-term.  So what does this money creation mean?

Basically, the Fed is buying government bonds from brokers.  The brokers buy the bonds from the government and the Fed buys the bonds from the brokers.  The Fed is basically handing over newly created money to the government, with a commission going to the brokers.  The government is handing over bonds (promises to pay) to the Fed.  The Fed’s balance sheet goes up.  The money that goes to the government did not exist before.  This increases the money supply.

If the Fed did not do this, the government would have a couple of choices.  It could balance its budget (yeah right) or it could sell its bonds to others.  Other purchasers of bonds could be individual investors, the Chinese government, the Japanese government, or mutual funds (which would be bought by individual investors) just to name some of the most common.  Since the Fed has also gotten into the bond buying business, the Fed will bid up the prices of bonds compared to what they would have been.  In other words, this lowers the interest rates on the bonds.

That is what QE2 does.  It is monetizing debt and by doing so, it is increasing the money supply and it is lowering interest rates.  The only catch is that because it is increasing the money supply, it is also increasing the risk of the value of the bonds (being paid back in depreciated dollars) which serves as a reason for rates to increase.  It basically causes a tug of war with interest rates.

We’ll talk more about what could happen with interest rates and bonds.  Although it is a tug of war and the Fed has a lot of power to keep rates low, it is unlikely that they will stay low for a long time, especially if the banks start lending out this money and we see massive price inflation.

With the Fed’s announcement of QE2 (more money creation out of thin air), it is becoming more likely that we will see high price inflation in the somewhat near future.  While a lot will depend on action by the banks, it wouldn’t surprise me to see the CPI rising at 15% or more in the next year or two.  I know that CPI isn’t accurate when it comes to reading inflation (monetary or price), but it is still useful to look at it to see trends.

The most important thing you can do is to have a portion of your investments, say 25% or maybe a little more in this environment, in assets that will do especially well in inflation.  I don’t like TIPS (bonds indexed to the CPI) because they are dependent on the government’s reading of inflation and they also are not a good hedge because they don’t go up in real terms.

Investments appropriate to hedge against inflation are precious metals and other commodities.  Gold and silver are the best metals, but I favor gold because it is less volatile.  Oil and food are important because we use these things in our daily lives.  Although traditional stocks may go up during inflationary times, they are not as reliable and will probably go down in real terms (inflation adjusted).  There are a wide variety of ETFs and mutual funds to invest in to get exposure to commodities.

While I will expand on these at a later time, there is something else you can do as a minor hedge against price inflation and you can’t really lose money on it.  It is something I’ve talked about before, but it is worth repeating.  If prices are going to be higher a year from now, why not buy things now instead of a year from now when prices are higher?  If you have storage space where you live, there are a lot of things that you can buy now and store for later.  I don’t recommend buying a house or car (unless you really need one and can afford one), but there are always things you know you will need.  Here is a sample list of things that you can buy now and store for later.  I’m sure you can add many things to this list:

Toilet Paper
Paper Towels
Kleenex
Laundry Detergent
Dishwashing Soap
Shampoo
Bar Soap
Toothpaste
Canned Food
Canned Soda
Bottled Water

Use the first in, first out method.  These are just a few things in a long list.  You will not become rich using this method, but you might save a few bucks down the road.  What do you think the chances are of these things being less expensive a year from now?  If you have the space, why not start buying in bulk? If you see a sale at the store, buy some extra.  If you buy $500 worth of stuff today and prices go up by 20%, then you will save $100.  If you wait for sales, you will save even more.

Again, this method won’t make you rich, but it is something easy you can do if you have the storage space.  If you have any extra money, it is better to buy cheaper goods now than to have it in a savings account earning less than one percent interest.

As news of the Fed’s announcement last week to buy $600 billion in U.S. government bonds is ingested, we have seen a lot of reaction to this plan throughout the planet.  Today, there is a story of one of the Fed governors, Kevin Warsh, who is now questioning the Fed plan.  Of course, he voted for the program, so it doesn’t mean much now.  There was only one Fed official, Thomas Hoenig, who voted against the measure.

In other news, Obama is in India right now and he spoke about the Fed plan.  When asked about international worry, he said that the Fed program would jump start the American economy and that that benefits other countries.  There is no polite way to say this, but Obama is an idiot when it comes to economics.  He has absolutely no clue and he has surrounded himself with Marxists and Keynesians, if there is a difference.  He believes that the government is the answer to all of our problems and he has no concept of how the free market works.

Meanwhile, criticism is growing from the international community.  Politicians from other countries are warning of consequences of the Fed plan.  Some of these warnings are accurate and well-founded.  Others are pure politics.  It’s not to say that the accurate ones aren’t playing politics, but at least they are right in what they are saying.

It is amazing how powerful the internet is.  It is also amazing how much of an affect Ron Paul has had, along with the other libertarians of the world.  There is a lot of criticism of the Fed that wouldn’t have existed 10 years ago.  There are a lot of people warning about the possible consequences of QE2 and how it may trigger inflation (QE2 itself is inflation, but we’ll cut them a break and assume they mean price inflation).

Tomorrow, I’ll discuss some easy ways to hedge against possible price inflation.  While there is no guarantee, it seems that much higher prices are looking more and more likely in our future.

During the fall of 2008, the big banks were bailed out.  They were bailed out by Bush, Congress, and the Federal Reserve.  The Fed more than doubled the monetary base in a short period of time.  This was a unique event in modern American history.

The massive increase in monetary inflation did not translate into massive price inflation.  The money that was created by the Fed went to the banks.  The banks have held this money as excess reserves.  Normally, the banks are only required to hold about 10% of deposits in reserve.  The other 90% is lent out.  If a bank dips below the 10% requirement, it borrows money at the overnight rate.  This is the Fed funds rate that is talked about so often.  Because most banks don’t have to borrow to meet their reserve requirement these days, the Fed funds rate is near zero.  The Fed says it is holding the rate near zero, but it is really the excess reserves held by banks that is keeping the rate near zero.  With massive excess reserves, most banks don’t have to worry about falling below the reserve requirement right now.

Since this money created out of thin air has been parked at the banks, it has not resulted in massive price inflation.  The money is not being lent out or spent.  It is also preventing the fractional reserve process from taking place.  In normal times, somebody would deposit, let’s say, $1,000.  Knowing that only a small number of people show up at any given time to withdraw money from their account, the bank would lend up to 90% of deposits.  In this case, the bank would lend out $900.  This $900 might end up in another bank and this bank would lend out 90% of $900 or $810.  This process keeps going.  This is fractional reserve banking.  It keeps going unless a lot of people start showing up at the bank to redeem their money.  This is a run on the bank.  The FDIC was created in the 1930s to protect people’s money.  This has prevented runs on banks (for the record, I’m not saying this is a good thing).  The fractional reserve process can also be reversed if banks stop lending money.

Two years ago, the Fed did something unusual, besides the massive increase in the monetary base.  The Fed bought mortgage backed securities instead of U.S. government bonds.  All or most of these mortgage backed securities were probably high risk loans.  Due to the popping of the housing bubble, there are a lot of bad loans that people can’t or won’t pay.  The Fed bought these for more than what they were worth.  This money went directly to the banks that used the money to increase their reserves.  The banks are probably scared to lend out this money because of what potentially lies ahead.

The next round of quantitative easing (QE2) involves the Fed buying $600 billion in U.S. government bonds.  This is a different scenario than buying mortgage backed securities.  However, this money could still end up parked at the banks.  Even if this newly created money went into the hands of average Americans, they will deposit it at a bank.  If the bank keeps this money on deposit and doesn’t lend any of it out, excess reserves can still go up more.  This would again prohibit the process of fractional reserve lending.  It would prevent a quick jump in prices.

This is a possibility, but it is also just as possible that this newly created money won’t sit at the banks.  This is what we need to watch.  If the excess reserves don’t increase with what is supposed to be an increase in the monetary base coming up, then we should expect high price inflation within a relatively short period of time, say a year.