Friday, August 31, 2012

Would The Fed Printing $50 Trillion Tomorrow Create Hyperinflation?

One of the best financial writers on the web today, Michael Shedlock who goes by "MISH," published an article this morning titled "Would Printing $50 Trillion Tomorrow Do Anything?"

It stemmed from one of his readers asking if printing that much money would cause hyperinflation. Mish has been one of the few steady deflationists over the past few years. His definition of inflation is an increase in the money supply and credit. Deflation is a decrease in the money supply plus credit. My definition is the same so we can have an apples to apples discussion here.

The problem that the Fed has faced in generating inflation is that we have a massive debt overhand that has built up over the past 40 years. When debts become too large a burden they default and the total debt/credit market decreases in size. This has a re-enforcing downward cycle on bank reserves which impact their ability to lend (grow credit) even further. The credit market in the United States grew from $1 trillion to over $50 trillion in 2008, and since then it has trended sideways and slowly risen due to massive government spending offsetting consumers deleveraging (paying down and defaulting on debt).

To complete the full scope of this discussion it must be looked at through a worldly lens as there are no borders today with capital flow. To understand how $50 trillion created by the Fed would impact the price of gasoline and food in America, you must look at currency and debt creation around the world vs. debt defaults and money contraction. I am going to table that part of the discussion today in order to help make it easier to understand. We'll just focus on the United States and pretend it is a closed economy (although I promise to take this thought process global in near future for those that want more).

Let's look at both pieces of the equation before we get started. The first is liquid cash, in which we have the Fed's M2 money supply to use as a barometer. This number just recently crossed $10 trillion.

Then we have credit. The following chart shows the most recent release from the Fed on total credit, crossing upward into new highs. We'll call this number $54 trillion (what's a few hundred billion in debt among friends right?). Total credit is composed of consumer loans (credit cards, student loans, auto loans, and mortgages), government debt (treasury bonds), corporate debt (corporate bonds), and debt from the banking sector.

The  last one, the banking sector, is where Mish focuses most of his attention during discussions on inflation. This is again correct as the banking sector is the most important of the four. Why? Because money is loaned into existence. I do not have the time here to explain this concept, but for those that would like a primer see What Is A Ponzi Scheme?

In 2007 the banking sector found itself loaded with residential and commercial real estate loans. Prices began to collapse on the assets behind this debt (real estate) making their portfolios underwater due to the significant amount of leverage they utilized on their balance sheets.

To counter this problem the Fed began QE1 which focused on purchasing mortgages and treasuries from banks in exchange for fresh cash. This lowered their leverage and began to alleviate the pain on their balance sheets. Due to the fact that banks were still underwater, they were taking the cash and parking it, not lending it out as they were before 2007 (this process is still taking place today). The following shows excess reserves at the banks as this new cash continues to be hoarded.

Why is this money not inflationary? Imagine that the Fed prints a trillion dollars and brings it to your home. You take the cash and put it in your garage and close the door. This is not inflationary because the money has not entered the economy. No prices are pushed higher with the cash just sitting in your garage, just as prices are not pushed higher with the money just sitting on bank's balance sheets.

So with this foundation in place we can go back to the original question: Would the Fed printing $50 trillion tomorrow create hyperinflation?

To answer this you must first think about what the Fed would purchase with this money. As a quick primer - the Fed creates money electronically by purchasing an item in the economy that is already in existence in exchange for cash. Imagine you have $1,000 in bonds in your portfolio. The Fed would pay you $1,000 in cash and take your bonds. You then have $1,000 in liquid cash to do with what you like (unlike the bonds which required you to sell in order to spend the money). This is how QE works and how the money supply is expanded (see m2 and bank reserve charts above).

So what would the Fed purchase with $50 trillion? So far they have purchased only mortgage bonds and treasury bonds. The entire debt of the United States government has just crossed $16 trillion. This means they have issued a total of $16 trillion in treasury bonds. The Fed already owns $1.65 trillion of this outstanding amount leaving a remaining $14.35 trillion in treasury bonds they could purchase.

There is currently about $13 trillion in total mortgage debt. The Fed already owns $850 billion in mortgages leaving about $12 trillion in available mortgage debt the Fed could purchase.

This means if the Fed purchased every available treasury and every mortgage bond around the world it would use up about $26 trillion of their available $50 trillion available to spend. That leaves $24 trillion to go.

At this point Mish does not think this $26 trillion in fresh cash now sitting available would create hyperinflation. His reasoning is correct in that most of it would be sitting as bank reserves that could only enter the economy as liquid currency through lending. However, we know that if banks felt their balance sheets were whole with most their debts liquidated then they could put this money to work in other areas such as commodities through their trading units instead of holding 100% of it in cash (sitting in the parking garage). Hold that thought, we'll come back to that in a second.

As a quick side note, I understand that this does not account for the shadow banking market. I will cover that as well in another discussion in the near future.

In his 2002 "helicopter drop" speech, where he promised to drop money from helicopters if needed, Bernanke provided multiple strategies for fighting deflation. The first three in the speech we have already experienced:

1. Lowering interest rates to zero
2. Buying treasuries and mortgages through QE programs
3. Providing long term "guidance" on rates (he has promised to keep rates at zero through 2014)

There is a fourth strategy that he discussed that is usually never mentioned. It can be considered the "nuclear" option. If the first three strategies did not work Bernanke said the Fed could begin to purchase assets outside of treasuries and real estate debt. This could be municipal bonds, commercial real estate, student loans, credit card debt, auto loans, stocks, gold, or your neighbor's fishing boat. The Fed could essentially wipe away the entire debt owed in the United States with a simple keystroke.

This debt is not exclusively owned by banks. The Fed would have to provide cash to insurance companies, pension funds, and every day people in the United States. Mish's argument is that the entire country, sitting on this $50 trillion in cash earning 0% which has been promised through 2014, would simply put it in their garage and never touch it.

He feels no one would buy stocks and more importantly they would not buy commodities such as oil, agriculture, copper, silver, or aluminum. If even a tiny fraction of that $50 trillion in fresh cash were to move into commodities it would create an unimaginable price spike which would in turn lead to a super surge in the cost of living.

To say that $50 trillion printed tomorrow would not create a hyperinflationary scenario is a silly statement. The next question, the one that is more important; what is the amount of printed currency (the magic number between $3 and $50 trillion) that would create a runaway inflation type scenario? That is what we will look at in part two of this discussion.