The Fed’s “Debt Monster” Is Calling the Shots

The Fed’s “Debt Monster”

Bill Bonner calls our attention to the danger:

You know our prediction: The Fed will never willingly lead interest rates to a neutral position.

It can’t. The FED  has created a debt monster. It must feed this Frankenstein with easy credit.

This time last year, the Fed began its “rate-tightening cycle.” That is, it began raising short-term interest rates.

It pledged to continue to do so in 2016. But then it diddled and dawdled, fiddled and fawdled… claiming to be on top of the situation… watching its “data” come in like a fisherman’s wife waiting for the return of the fleet… and not wanting to admit she was already a widow.

What it was really waiting for was a place to hide.

The Fed can raise short-term rates. But it will have to follow, not lead. It will have to hide in the shadow of rising consumer prices, staying “behind the curve” of inflation expectations.

That way, the expected real interest rate – the rate of return on your money above the rate of consumer price inflation – never really returns to neutral.

Already, the price of a barrel of crude oil – a key input into prices across the economy – is twice what it was 10 months ago. Leading business-cycle research firm the Economic Cycle Research Institute says the inflation cycle has turned positive.

And already, foreign nations are talking about retaliating against Team Trump by canceling orders and imposing new tariffs in their own versions of “better trade deals.”

This, too, is bound to raise prices.

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Funny Money Antics

But if consumer price inflation were really a concern, the bond market would race ahead of the Fed, imposing its own regimen of rising yields.

The Fed’s increases would be too little and too late to have any real effect on the outcome.

Bondholders don’t care much about nominal rates. If consumer price inflation were to rise to the Fed’s 2% target, for example, bondholders might clamor for a 4% yield to give them a positive 2%.

That is a big increase over the 52-week low of 1.32% the yield on the 10-year Treasury note hit on July 4.

But you don’t get that kind of seismic shift without cracking some flower pots.

Much of the world’s $225 trillion in debt is calibrated to borrowers who will have a hard time surviving a 3% interest rate world, let alone a 4% one.

This is an economy that can stand a lot of grotesque and absurd “funny money” antics. It can survive a bizarre financial world; it can’t survive a normal one.

As inflation expectations increase, investors do not sit still and watch their retirements, their savings, and their fortunes get broken by inflation.

They don’t wait for the Fed’s policy-setting committee to meet. They don’t reflect calmly as the Fed’s wonks collect their “data” and create their “dot plots.”

Instead, they act out. The monster gets mad and starts throwing things.

First through the window are the bonds. They get chucked out before inflation manifests itself fully… and long before the Fed increases its key short-term rate.

Then, the “boom” turns quickly into stagflation… as higher borrowing costs pinch off growth even as consumer prices continue to rise.

But more likely, inflation is not really surging… Not yet.

And most likely, it will be the painfully apparent when the U.S. economy goes into recession next year.

Then, it will be stocks’ turn to get tossed out, while bonds sneak back in through the side door.

It will also be apparent that the Fed has taken another false step… that the recovery was a sham… and that it’s the debt monster calling the shots, not Janet Yellen.

Regards,

Bill Bonner

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