Many economists have been predicting for quite a while that the Fed’s actions would lead to inflation. And yet, for the last decade, we have seen deflation, if anything, in most of the western economies.
In this article, I will discuss why this has been the case, and why I expect this to change shortly, meaning I predict that we will see higher levels of inflation within the next 5 years. Increased use of fiscal policy together with a loss of value in the dollar will lead to worldwide inflation. This, in turn, will mean higher interest rates and the beginning of a bear market in equities. Gold and value stocks will outperform when this happens.
Where’s the inflation?
Despite unprecedented amounts of “money printing”, inflation has failed to pick up in western economies. This has left many dooms and gloom economists wondering how exactly their predictions went wrong. The answer is simple, while the Fed can certainly control the quantity of money, it cannot control its direction and velocity, as shown by the increase in bank reserves.
In simple terms, a great majority of the money “printed” has gone and stayed in bank reserves. The current level of reserves is staggering when looking back at what it was in the 90s. With every crisis and subsequent Fed response, we see an increase in reserves. It happened in 2008, 2012, and at an even bigger rate in 2020. This is a sign that this money is not going where the Fed would want it to.
The Keynesian idea is that lower interest rates will be reflected in more borrowing and spending. Instead, this money is sitting in reserves, and the only ones borrowing are governments and big corporations, which in turn have used this money to support their share price through buybacks. But worst of all, the lower interest rates are propping up what may have called the “zombie” economy.
The Zombie economy
The idea is simple, rather than allowing new businesses to flourish, lower interest rates are propping up failing businesses and allowing them to continue. This is true for businesses and some of the big banks.
In macroeconomic terms, what low-interest rates are doing is preventing the economy from deleveraging. Initially, low-interest rates make the economy “artificially” become more indebted than it should be. This should be followed by a corrective time where the economy reduces its debt levels. However, by continually lowering rates the Fed is preventing this. Why? Because deleveraging is bad for the economy. Or rather, it looks bad. Deleveraging means companies going bankrupt, and this will of course hurt the economy and the market. But this is a necessary evil if we want to free up resources for more productive activities.
Unfortunately, this hasn’t been happening, or at least not fast enough. Instead, we continue to be stuck in this zombie economy. Only one thing will change this, and that is inflation.
Inflation, then deflation
For now, the Fed has been able to lower rates without any of the “bad” consequences. One reason for this is the increase in reserves. But the other is that no matter how many dollars the Fed prints there is always international demand for it. As the world’s reserve currency, the dollar holds this privileged position, but this could change quickly.
There are a few ways the ensuing inflation could unfold. One scenario is that the Fed gets its wish and the U.S. economy stats indebting itself again. As the economy “overheats” we will see a similar thing happen to the 2000-2008 period. Assets prices will increase, and so will regular prices. With all this new credit finally reaching the main street, we will finally get the inflation created by more money chasing fewer goods. As inflation comes out of control, the Fed will be forced to increase rates to contain it, which will then spark the so needed deleveraging. Of course, with deleveraging, also comes deflation. However, this deflation will be much more severe than what we saw in 2008, simply because there is so much excess liquidity in the system.
There is also another way this could go down though. The dollar could slowly lose favor as the reserve currency. One way this can happen is if another country becomes dominant enough to impose its currency on other countries. This could happen easily if we see a gold-backed currency and even gold-backed bonds. The main advantage of holding dollars over gold, right now, is that it Treasuries pay an interest, albeit a low one. However, Turkey has now issued gold certificates, which pay interest, in gold. In other words, gold is slowly recovering its place as a monetary asset, which could potentially displace the dollar. In this scenario, lower demand for dollars would devaluate the currency. To prop up the value, the Fed would have to increase rates, or rather reduce the money supply. Alternatively, they could do nothing, but then again this would lead to domestic inflation as imported goods become more expensive. The result, in any case, is inflation and higher rates. Followed by deflation and a prolonged bear market in equities.
Gold is Money
Although most mainstream economists won’t tell you this, gold (NYSEARCA:GLD) has for most of its life, and until 1973, been considered a monetary asset. Gold is money, which is why it still plays such an important role in our financial systems and why every central bank still owns gold. With the price rallying to all-time highs, it is safe to say that more people are becoming aware of the importance of owning gold.
Gold not only provides a hedge against inflation, but it also provides a hedge against deflation and it is the ultimate store of value. Until now, in times of distress, money has gone into gold, but more so into dollars and treasuries. But increasingly, the money going into dollars will now move into gold, especially now that it can potentially pay an interest.
Any prudent investor now would do well in owning mining stocks and even physical gold and silver. From a macroeconomic perspective, I expect the current bull market to continue higher, perhaps aided by the higher inflation. However, once the Fed raises rates and deflation sets in, we are in for a long bear market where, in my humble opinion, gold, value and select technology companies will reign supreme.