Sophie’s Choice

In this 1982 movie based on a novel by William Styron, a young mother on her way to a Nazi concentration camp had to make a horrible choice - which one of her two children would she send to the gas chamber and which one would she save? This is where the Fed finds itself today. They are on a tightrope between two horrible choices. 1) Raise interest rates to defend the dollar and choke off price inflation which in turn will likely cause huge problems with the mountain of debt our country has piled on and will burst the housing bubble or 2) leave rates low, knowing price inflation will surface as the dollar falls and all those cheap imported goods rise rapidly in price. This in turn would be likely to produce a loss in confidence of the US dollar in the currency markets. Either scenario will likely bring about the death of the US dollar as the world’s reserver currency.

The first choice involves playing with a deflationary depression similar to that of the 1930’s as the money supply is held in check and debt defaults skyrocket forcing mass closings of banks and widespread loss of capital as the stock markets crash.  The latter choice would force the government to inflate and possibly hyperinflate the currency - essentially destroying it as they pay off existing debt with dollars worth far less in terms of purchasing power. Based on comments by Fed governor Bernanke and current monetary policy, it appears as though the choice is being made to sacrifice the currency.

Why Choose Inflation Over Deflation?

While inflation is bad and hyperinflation is very bad, deflationary depressions are horrendous. Having gone through a deflationary depression in the 1930’s means that politicians most likely will not let that happen if they can help it (as again evidenced by Mr. Bernanke’s comments). The benefit of a hyperinflation from the government’s perspective (if a silver lining could be found) is that when it is over, they would be able to pay off its over $50 trillion of dollars in liabilities with worthless dollars prior to installing a new currency. This has been done in the past. Don’t think our government would not do the same.

Why does the Fed have to make a choice between these two? Why is one or the other inevitable?

Price inflation is coming in a big way as energy prices continue to rise and the US dollar continues to fall. Remember, the whole point of the dollar falling is to make our imports more expensive and our exports less expensive overseas in order to balance the trade deficit. The problem is that because of China’s peg of the yuan to the US dollar many of the goods we buy haven’t been subject to those corrective forces - yet. China has begun the process of re-valuing its currency. As it does, this will raise prices on imported goods - walla - instant price inflation.

The CRB index which measures commodity prices of raw goods (price of “things”) has risen dramatically in the last few years. Just look around. Gas is nearly $3 per gallon, milk has risen by 50 cents a gallon.  Wheat, corn, soybeans are all up from 20% to 80% in the last two years, insurance premiums are going up by 20% + per year, and the list goes on.  Why then do the government statistics show low inflation?

Now it gets even more complex. The bottom line is that government statistics on inflation are rigged and understate price inflation by 2 to 4 percentage points. Real price inflation in the US is running from 6% to 10% per year. We are seeing big increases in prices of things we need (i.e. food, energy, medical care) and no increases in the things we don’t need (i.e. DVD’s TV’s, Ipods, computers, cars, etc.) I won’t go into exactly how the statistics are rigged here. A very good article called The Core Rate explains it well. You can read it at your leisure. There is also a very good interview (requires Real Player) from “Financial Sense Online” that points out that if the CPI were measured using the same methods as in 1993, our price inflation would be reported at 8% to 10%.

Why cover up inflation? Back to interest rates... The only way to combat inflation is to raise interest rates higher than the inflation rate and trigger the economy to slow down in order to reduce demand - and our Fed does not want that to happen. They can’t! The economy is slowing now in the face of a Fed funds rate at 4.5%. Can you imagine the carnage if they had to raise it to 8% or 10%? The global economy would come to a halt!

The Box:

With the tremendous structural imbalances in the economy today, the Federal Reserve finds itself in a box. The US economy since 2001 has been built on an environment of ultra low interest rates. Debt levels have grown to such levels that if interest rates were to rise too far, servicing those debts would become more and more difficult for companies, individuals and our government. Consider this:

• Ford and General Motors recently had their bonds lowered to “junk” status because of the damage rising interest rates have had on their debt positions. It is no coincidence that these are two of the largest manufacturers in the US. They just can’t compete any longer in the global economy.
• Interest rates, despite rising for two year are still below historical norms.
• The US has a housing bubble has burst. The results are yet to be seen.
• The US consumer has relied on being able to refinance their home in order to pay off credit card debt and purchase new toys. That ATM has closed for business.

Once again, if interest rates rise too far and too fast to combat inflation, the Fed risks a collapse of debt and a deflationary depression. If they leave rates low and increase the money supply to counteract the deflationary pressures they risk a hyper inflation as the dollar collapses. The modern day economic Sophie’s Choice.

Where are we going?

Short term, it appears as though the Fed has adopted the policy of erring on the side of allowing some inflation, hoping that the imbalances will be worked off with a lower dollar without inflation getting out of control. They will do this by raising short term rates, but keeping them below that of real price inflation in order to protect against a debt collapse and to enable consumers to continue to create more credit in order to feed consumption. The US dollar will continue to lose value, driving up import prices. A key event will be how quickly the Chinese allows their currency, the yuan to rise against the dollar. This process has begun and will have significant consequences going forward.

The Wild Card - Interest Rates Rising Out of Control

This policy has its own set of additional significant risks. Foreigners own more US debt than at any time in history and it is growing rapidly.

As much as the Fed and the markets like to tell you that the Fed is in control of interest rates, it just isn’t true. The only rate the Federal Reserve controls is the discount rate - the rate charged between banks for overnight loans. That’s it. The bond markets determine all other rates. True they take their cue from the Fed, however they do not always follow in lockstep what the Fed would like to see. When the Fed looses influence over rates, we enter dangerous waters because the Fed relies on predictable rates to set policy. In Fed speak, this is known as a “conundrum”.

If foreigners (mainly China and Japan) decide they no longer see US debt as safe, or if they see the US dollar falling rapidly (which means their US dollar denominated debt holdings are losing value) and start sell dollars rather than buy our debt, the US dollar will collapse, interest rates will rise rapidly, the US economy could self-destruct in a manner that would place the world financial system in great peril.

As the renowned economist Ludwig von Mises warned us decades ago: "There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved." [Human Action, Regnery, 1966, p. 572.]

So that is where we are today. Can the Fed walk this tightrope? I hope and pray they can. Here is the one thing that we have going for us: The US dollar is the world’s reserve currency. Most of the world’s international transactions are in US dollars. If the US dollar were to decline in value too far, too fast, the entire world economy would be at risk. Because of this, other nations both friend and foe will extend a wide berth to assist the US deal with her problems. Some argue that this just adds fuel to the fire as we continue to consume and borrow in excess rather than taking steps now to deal with our imbalances.

Here are some easy to watch sign posts to use as early warning signs if things are getting out of control (see accompanying charts):

1. US dollar value - has decisively broken below multi decade support at 80. A break below 72 would mean severe trouble would be directly ahead. USD Chart 3 Year
2. Price of Gold - Gold has risen to over $900 per oz, and this is a clear indication that there is real concern worldwide regarding the condition of our fiat money system and that a flight to commodity money has begun. Gold Chart 3 Year
3. Interest rates - if the 10 year treasury yield breaks above 5% this will be in indication that the bond market either sees inflation for what it is (a real and present danger) or the US dollar is in trouble - or both. 10 Year Treasury Chart 3 Year

Notes to Remember:

• Because of the imbalances in the economy the Fed is in a box walking a tightrope between inflation and deflation. At some point in time they will be forced to pick one or the other.
• I believe they will choose inflation over deflation. They have themselves indicated that would be their preference.
• Inflation is grossly understated in order to calm the bond markets and not let rates rise too quickly.
• Any geopolitical event such as a major terrorist attack would trigger a hyper inflation as the Fed would respond by “liquifying” the market - printing vast quantities of money and lowering interest rates - triggering a collapse in the US dollar.
• All of this assumes the US maintains control over their debt and interest rates. The US is a debtor nation. If foreigners lose confidence in our ability to service this mountain of debt, the results could be devastating.
• We are talking about the US and global economy here. These things will unfold over a long period of time in the absence of a geopolitical event. Months or years, during which counter trend movements will be seen in the sign posts (i.e. a period of months where the US dollar rises, gold falls and interest rates fall). This does not necessary signal a change in fundamentals. It is the market sorting out where the truth lies. Just as we are trying to do here.

In conclusion, please know my heart. This information is not intended to cause us to live in a spirit of fear, but to just practice Proverbs 22:3. To recognize danger when it is near. To prepare for it if it threatens. And to seek refuge in sound Biblical principles for living and handling our own finances.

How can you Protect Yourself?