This article was posted on Friday, Mar 30, 2012

The below article was written by Robert Wiedemer  who is the author of The New York Times and Wall Street Journal bestseller, Aftershock: Protect Yourself and Profit in the Next Global Financial Meltdown, with over 500,000 copies sold. He is a managing director of Absolute Investment Management, an investment advisory firm with more than $200 million under management (

In the pages of Financial Intelligence Report (FIR), we have written at length about our firm belief that critically high inflation is coming to the U.S. Many have doubted us, pointing to indicators such as the Consumer Price Index ” still at a modest 3.8 percent ” and wondering what all the fuss is about.
‘s true that 3.8 is not the sort of number that would indicate high inflation is just around the corner. However, does that mean it won’t come? Absolutely not.
Fundamentally, when the government expands the money supply much faster than the growth in our GDP, we will get inflation.

And that’s exactly what the government has done. We have increased our money supply by over 200 percent since 2008, whereas our GDP has barely grown at all since that time.
But, in any inflationary scenario, there is always a lag between when the money supply is increased and when it manifests itself in inflation. The key question for investors and economists is, how long is that lag and what exactly will it look like? Specifically, what is the tipping point between relatively low inflation and high inflation?

The Two-Year Lag
In a normal economic situation, the typical lag factor between increases in the money supply and inflation is around two years. This lag factor is fairly well accepted in the economics community. In fact, in a paper coauthored by current Federal Reserve chair Ben Bernanke in 1999, a survey of economists concluded that the normal lag factor between money supply increases and inflation is 18 to 24 months.
However, there are a number of factors that can increase that lag. They don’t prevent the onset of inflation, but they can postpone it.
One such factor is banks holding a lot of the increase in the money supply in excess reserves. This is happening now. As we can see from the chart below, the amount of money held in excess reserves has skyrocketed.
These reserves are called excess because the Federal Reserve does not require banks to hold them to fund normal banking operations. (The requirement to hold funds exists because a bank can’t be allowed to lend out all of its money, even though that would be more profitable, because it would be more vulnerable to a run.)
As borne out in the chart, in the past, banks have had no incentive to hold excess reserves because they damage their profits. Whether the economy was good or bad, banks simply didn’t hold excess reserves. That suddenly changed in 2009. Why?
Clearly, the Federal Reserve is putting pressure on the banks to hold excess reserves, now at historically unprecedented levels. In addition, it pays the banks 0.25 percent interest on their excess reserves, which encourages the action.
Also, it is important to point out that the money supply has increased by almost $2 trillion, whereas excess reserves are only $1.6 trillion, so a significant amount of that money has already slipped out. In fact, the amount that has been released is equivalent to almost 50 percent of our entire money supply in 2008. So, this is a factor that is postponing the onset of inflation but not preventing it.

Inflation: A Monetary Phenomenon
Another factor to consider is a slow economy could dampen inflation. In a slow economy, it’s hard to raise prices. That makes sense. However, massive increases in the money supply will overcome that, meaning it may cause a lag but it will not ultimately prevent inflation.
Think about it: Zimbabwe has a very slow economy, for instance, but a very high rate of inflation. In fact, the last time the U.S. economy had high inflation was when it had a very slow economy in the late 1970s and early 1980s. This was called stagflation. But, in reality, most inflation does occur in a stagflation scenario. That’s because when the economy is heading down, governments lose tax revenues and at the same time often have rising expenses. Hence, they resort to the printing press to fund the money they need.
If the economy is slow and the government prints money, you will have inflation. But, if the economy is slow and the government does not print money, you will have deflation. Inflation is not controlled by the growth of the economy, but by the growth of the money supply. This is a key aspect of inflation. As Milton Friedman, the Nobel Prize-winning economist and monetary policy expert said, Inflation is always and everywhere a monetary phenomenon.
De-leveraging is also talked about as a reason we won’t get inflation. However, leverage is not what causes inflation ” once again, increases in the money supply cause inflation. Did we get massive inflation when we up-leveraged over the past decade? No.
Hence, we won’t get massive deflation if we de-leverage. And, the actual amount of deleveraging has not been that great so far. We are not up-leveraging like we used to, but we are not de-leveraging to that great an extent either. (For more information on inflation, please see Chapter 3 of my book, Aftershock, which provides a more detailed explanation of the workings of inflation and the many reasons people don’t think it’ll happen.)

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Inflation on the Rise
In the great debate over inflation, it’s important to point out that although we don’t have high inflation yet, we do have much higher inflation. Inflation has increased dramatically over the past couple of years from an annualized CPI of 1 percent in late 2008 to an annualized rate of 3.8 percent today. Although that is not massive inflation (yet), that does represent a massive increase in inflation. And, that increase in inflation came during a slow economy ” the Great Recession, as many people have called it.
Also, it is notable that the calculation of the CPI was changed under previous Fed Chairman Alan Greenspan to reduce its rate of growth. In fact, according to Shadow Stats, the CPI today, if calculated as it was by the Federal Reserve in 1990, would be 7.1 percent.

We all feel that higher rate of inflation in our pocketbook. Who isn’t seeing the effects of inflation in their food, energy, healthcare, and education costs?
However, the government, the financial markets and the financial press are driven by the CPI, not by the rate of inflation we feel in our pocketbooks. Hence, it is easier to argue that inflation is not a concern. A misleading calculation of inflation is another way of postponing the onset of inflation, but we all realize it can’t prevent it. That’s because in the long run, inflation will get high enough that even misleading statistics will show high inflation.
‘s also worth noting that other countries that have resorted to using the printing press to boost their economies are seeing much higher inflation now. One of the biggest money printers, China, is the most notable example, with an official inflation rate of 6.5 percent, although the real inflation rate is much higher than that. Another big money printer, Britain, has also crossed the 5 percent inflation threshold.

The Key ˜Tipping Points’
The first real tipping point is five percent to eight percent. Less than five percent inflation can be almost completely ignored by the financial community.
However, as it crosses 5 percent, inflation perceptions begin to change. A number of people in the investment community will begin to worry. ‘ll cause increasing unease in the financial markets, especially as it approaches 8 percent. Gold will begin to rise more steadily.

Most importantly, the Fed will have to be more careful about increasing the money supply just to support the stock market or boost the economy a little. It is likely that we will have crossed five percent inflation by the end of 2012.
However, at this level, many people will not be worried. Plenty will even contend that five percent inflation is a positive. Already, some are touting it as a way of dealing with our massive government debt. Economic cheerleaders will have a relatively easy time of denying that inflation is a problem. Inflation will not affect interest rates too much at that stage, and the Federal Reserve can print money to keep interest rates low.
The bottom line is at this stage, only a minority will see a problem, but the fact that a minority of the investment community is starting to see a problem is a real tipping point.
The second real tipping point is 10 percent. At 10 percent, everything changes. The cheerleaders will no longer be able to deny that inflation is a problem. Conventional wisdom will reflect much greater fears over inflation. There may even be calls for wage and price controls. Fairly rapidly, the real estate, bond and stock markets will become destabilized. None of these markets anticipated any significant inflation, and they will be quite shocked that it is happening. A small-scale panic will begin.

Normally, the financial community would look to the Federal Reserve to bail them out of their increasing numbers of bad loans, falling stock market and collapsing bond markets. But, increasingly, the Fed will be seen as the problem, not the savior. The one financial problem the Fed can’t solve by printing money is inflation.
The Fed currently would assume that it could pull the printed money out of the system at that point. They would also assume that the naturally rebounding economy and years of strong economic growth would allow them to pull the money out without hurting the economy.
But, this is where Fed leaders are making a fundamental mistake. They do not believe we have a bubble economy. Bernanke and his cohorts believe we are simply in a down cycle that we are guaranteed to pull out of.
The problem for the Fed is that we are indeed mired in a bubble economy. Not just one bubble, but multiple interacting bubbles (housing, consumer spending, private credit, and the stock market). When these bubbles pop, they don’t automatically re-inflate.
So, instead of providing stimulus to get us through a down cycle, the huge money printing operations of the Fed, which have helped support the massive borrowing operations of Congress, are simply keeping the bubbles pumped up. They are actually creating the biggest and worst bubbles of all ” the government debt and dollar bubble.

10 Percent Is Only the Beginning
Because we are not simply in a down cycle, the Fed will find that there is no good time to pull money out of the system. It certainly won’t be when the economy hits 5 percent inflation. And, it most definitely will not be when we hit 10 percent inflation. In fact, that’s when the Fed will be forced to print more money.
Right now, money printing is discretionary. It is being used to boost the stock market and to prop up otherwise slow economic growth. But as the panic of 10 percent inflation starts to melt down the financial markets, the real money.
At that point the Fed will have to print money to provide the liquidity necessary to keep the financial markets from freezing up. It will also need to print money to offset the steep drop in capital inflows from foreign investors due to the chaos in our financial markets. When that inflow becomes an outflow, the Fed will have to print even more greenbacks.
Unemployment will be rising very rapidly at that point. The Federal Reserve will be under enormous pressure to boost the economy with more printed money. But printing money in only the amounts of the QE1 and QE2 programs won’t work anymore.
They will need to print much more to have an impact on an economy where the unemployment rate will begin to approach 15 percent and higher.

Needless to say, the federal government’s deficit will be expanding enormously, which will force the Fed to support massive borrowing with massive printing. Otherwise, the government won’t be able to borrow the money it desperately needs to offset rapidly declining taxes and soaring social expenditures.
The other problem facing the economy when this happens is that inflation expectations will have changed dramatically. The lag factors discussed at the beginning of this article will be much less important. The lag between increases in the money supply and inflation will shrink dramatically. This will have the effect of accelerating inflation.
Once inflation starts, history shows that it is hard to control and tends to accelerate more rapidly over time. Hence, the real problem from inflation will come not just from what we are printing now, but from what we will be printing in the future.
Although this may sound very dramatic, it is a rather typical inflationary spiral that many countries have gone through in the last century. The big difference is that it is happening to the U.S., where it has never occurred before because we have never done what other countries have done. That’s why financial markets have so much faith in us right now. But, the United States has changed. We are now doing what other countries have done in the past and hence we will encounter similar problems without easy solutions.

‘s not that we will collapse as a nation. In fact, I think we will come through this much stronger and better than before. That’s also not too different from other countries. Think of Germany or Brazil, which have gone through inflationary spirals and come out of them even stronger. We will too. But, our sterling reputation for financial management will have been damaged. Our financial markets will also change dramatically. And we will have learned an important lesson. It won’t be fun; lots of people will be financially hurt and be very angry.
But, inflation tends to hurt those most who prepare for it the least. There are many ways to protect against inflation, as we have discussed many times in FIR and will continue to in the future. Just remember, the most important step in shielding yourself against inflation is recognizing that it can happen. To that end, we will continue to keep vigilant watch for those critical tipping points, and keep you apprised of what to do next.

Reprinted with permission of the Financial Intelligence Report. To receive a free four-month trial period to Financial Intelligence Report along with the special report The Coming Dollar Devaluation, simply call 1-800-485-4350 ext. 2172 or go to

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