Hopelessly Devoted To Inflation

In the middle of July the stock market finally awoke from its QE-induced coma and realized the Federal Reserve’s tapering, which has been going on for the last six months, was for real.  Like a child, who becomes accustomed to a parent that threatens punishment but never follows through, the market had been in denial to the Feds withdrawal of monetary stimulus. But now, thankfully, the ending of Fed asset purchases will be the pin that pops this QE-inflated market and economy.  But please do not confuse the end of QE with the Fed actually fighting inflation and selling trillions of dollars’ worth in Treasuries and mortgage backed securities (MBS)…because that will never happen.

The Fed has increased its balance sheet by an unprecedented $3.5t since 2008. They accomplished this by purchasing Treasuries and MBS from banks in exchange for Fed credit.  A credit from the Federal Reserve is a nuanced way of saying “new money”.  This new money is transferred as a credit to the banks with the idea that the Fed can and will reverse this transaction at its discretion.  Like an army releases reserves, the Fed (with the help of private banks) has marched many of these new dollars into the economy to “save us” from deflation.  Once the job is done, the Fed intends to call these dollars back and shrink its balance sheet back to pre-crisis levels.  This all sounds great in theory, but as we will soon see, the practical applications of shrinking the Fed’s massive Balance Sheet has become impossible without creating a monetary depression.  

For the past few years, the central bank’s credit and inflation has been predominantly deployed in bonds, real estate and equity assets. However, recently this new money has leaked into the government’s manipulated CPI calculation. Therefore, our government can no longer promulgate the lie that inflation is some elusive goal that it cannot achieve. And, the argument that stronger economic growth is around the corner in a context of low inflation has been fully debunked. That is why the market sold off last week. In a word, it is inflation. The Employment Cost Index (ECI) component in the GDP data put the Keynesians on “high wage inflation alert”.