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Dear Fellow Investor,
Inflationary pressure is building, but don’t expect the Federal Reserve to stand in its way.
Numerous outlets have pondered the central bank’s limp approach, its reluctance to raise interest rates, or to do so at piecemeal rate. The Fed’s own survey of projections place inflation at above the 2 percent target for the first half of 2018, and yet the federal-funds published rate remains at 1.75 percent, with an effective rate of 1.69 percent.
Many forecasters, such as Kiplinger, project inflation rates at nearer to 3 percent, on account of rising medical costs and instability in crude-oil production. Escalation of military conflicts in the Middle East would amplify the inflation problem, as would a trade war with China, if it were to reach sufficient magnitude.
One need not be a mathematician to see that this all equates to a negative real interest rate in the U.S. economy, with no end in sight. There is a reason the Fed is not putting up a fight, an ominous elephant in the room.
That elephant is represented by the mountains of debt at all levels of government across the United States, often off the books as unfunded liabilities — not to mention private credit-card and student debt. These governmental institutions, already with the power to tax, have insatiable appetites. They have become accustomed to near-zero interest rates, and they are ill prepared for their departure.
The prospect of widespread defaults looms large, and not only in California, everyone’s favorite whipping boy. The painful fact is that dozens of cities have declared bankruptcy in recent years, and any increase in interest rates will place enormous pressure on jurisdictions already facing fiscal crises. Even for those not near the point of default, higher interest rates mean ever larger debt-servicing costs, which transfer tax dollars away from government services and place the squeeze on rising pension costs.
In the case of the federal government, debt servicing is around $300 billion per year. Each percentage-point rise (100 basis points) adds between $1.5 trillion and $2.9 trillion to the national debt over a decade. A rate of 6 or 7 percent, in line with levels in recent decades, would swiftly balloon annual deficits and the national debt. The latter has already surpassed 100 percent of GDP, an indicator of economic vulnerability and lower growth.
Unnaturally low interest rates are a de facto bailout for too-big-to-fail governments, paid for by all holders of U.S. currency, at home and abroad. This tax is well known to gold bugs and to professional economists, but it still flies under the radar of the general public. Even if the populace notices higher prices, politicos can easily deflect concerns and point to scapegoats.
Where the story gets prickly, however, is in the long-term outlook for the U.S. dollar as the world’s reserve and most used currency, without peer. The one saving grace for the United States is that prospective competitors, such as the euro, are in more-dire straits. Under the Trump administration, U.S. economic growth remains similar or better than that of the European Union, which is under a cloud of likely fragmentation, while U.S. unemployment is back to historically low levels.
The dollar’s stability is precarious, though, as recently highlighted by Olav Dirkmaat, a Dutch economist writing for the American Institute for Economic Research. Dirkmaat uses the downfall of the Argentine peso as a case study and warning, highlighting the Fed’s volatile assets:
“The bad news is the Fed’s mortgage-backed securities portfolio, which makes up roughly half of its balance sheet.… In a worst-case scenario, the prices of these securities would suffer dearly during a downturn.
“Moreover, the maturities of the Fed’s assets are long — extremely long. This means that if interest rates rise, the Fed’s assets will suffer price drops.”
In other words, “the Fed might suffer the dire consequences of an impaired balance sheet in the future.”
One outcome is guaranteed from the Fed’s fecklessness: the swift erosion of the value and purchasing power of the U.S. dollar. While the Fed’s hands are tied, artificially low interest rates and inflation may not bring an end to the dollar’s reign any time soon, but little by little they chip away at its dominance.
The rising tide of inflation is bullish for gold and underlines the need to be weary of bonds and all dollar-denominated securities. Further, a weakening dollar is a gift to the many alternative cryptocurrencies fighting for a place as a medium of exchange.
Fergus Hodgson is an economic consultant and Gold Newsletter’s roving editor.
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