Beware: The Inflationary ˜Tipping Point’ Ready to Hit the U.S.
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 (absolute-im.com).
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
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
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
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.)
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
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
‘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
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
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 fourmonth
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