The Fed Loses Control Of Inflation...

London, England

The world is in danger of a "global stock and credit crash," says the Royal Bank of Scotland.

A "very nasty period," may be coming, it goes on, as "the chickens come home to roost." Morgan Stanley also warns that a ‘catastrophic event’ may be coming, caused by the collision between Europe’s tight monetary policy and America’s loose one.

Surging inflation all over the world is putting pressure on the Fed to raise rates. But raising rates in an economy with rising employment and falling house prices could be disastrous.

On the other hand, not raising rates could provoke a disaster of its own. It could cause the dollar to collapse as prices soar.

On Friday, the Dow fell 220 points. Gold held steady at $903. Oil rose $2 to $135.

Here at the Daily Reckoning headquarters our "Crash Alert" flag has been up so long it’s almost in tatters. Even we don’t bother to look up any more. We know what to do — keep our money in cash...in gold...in Japan...and, lately, in emerging markets.

But the best place for you money over the last year has been energy. Energy stocks on the S&P are up about 20%. The worst place for your money has been the financial sector, which is down about 36%. The banking index, BKX, was at 110 last year. Now, it’s below 65, down about 40%.

The Fed is fighting a mighty war against deflation...and losing. Its cheap money and credit no longer seem to help its buddies on Wall Street or the little guy out on the prairies or down in the bayous. Instead, the money drives up consumer prices...and ends up in the hands of the energy exporters — Russia, Venezuela, and the Gulf. The Financial Times reports that there are 15 times as many houses for sale than there are buyers looking for them. And now, it appears that the very temporary boost given to the US economy by the tax rebates is fizzling out. Look out below...

But you rarely get what you expect from the financial markets; instead, you get what you deserve.

Wall Street is getting what it deserves. The hotshots made fortunes by loading up the whole country with debt. Finally, they’re taking some losses.

This point deserves a brief pause. Stephen Cecchetti, writing in the Financial Times, argues that Wall Street’s innovations of the last 20 years were a great thing, in that they helped cause ‘the Great Moderation.’ He’s referring to the period of steady growth, with less volatility, over that period. The key to it was securitization, he says. By turning loans into credit-backed securities, the financial industry not only did itself a huge favor, it did the whole world one too, he believes.

How so?

"Not only has the overall quantity of financing increased, but also these innovations have allowed high-risk borrowers access to financing...there is a clear sense that financial innovation has been responsible for reducing the previously direct relationship between consumption and income." Mr. Cecchetti, a professor of finance, sees this extra credit as a triumph. We see it as an attractive nuisance. Like a hand grenade on a playground, the kids are bound to start playing with it, until it blows up.

In 1985, there were only $1.6 trillion in home mortgages. And only $500 billion worth of them were in pools used to back securities. Twenty years later, total mortgage debt approached $10 trillion, with $7.5 trillion of it securitized.

This "financial innovation has been responsible for reducing the direct relationship between consumption and income," he adds.

Again, the professor regards this as a victory. To us, it is the kind of victory won by George Armstrong Custer at the Little Big Horn. The financial innovations of the last 20 years lured Americans to go deep into dangerous territory — increasing their spending, even though their incomes were stagnant. This "smoothed" growth in the world economy. Economists loved it. But it wasn’t long before the US consumer had slumped over — wounded by excessive debt.

America’s central bank tries to come to his rescue...but when the cavalry finally arrives, they gallop right over him.

What the US economy desperately needs and richly deserves is a slowdown. People borrowed too much...and spent too freely. Now, they have to cut back and pay up. The sooner they get it over with the better; clearing away excessive debt and cleaning up balance sheets will give them something solid to build on. Of course, it won’t be easy or painless. Before it’s over, the spendthrift consumer will feel like a Zimbabwe voter.

But the Fed is doing all it can to avoid a slowdown. That is why we have the key Fed rate at a NEGATIVE real yield of 2.2%. And it’s why when you put money in a money market fund you get a return of less than half the rate of consumer price inflation. The low rates discourage you from doing what you ought to be doing — saving money rather than spending it. The 90-day T-bill rate is only 1.8%. That’s part of the reason gold is so expensive; you don’t give up much income to own it.

Usually, the regret phase of the financial cycle has its own rewards. There are fewer cars on the road...and it is easier to get a reservation in a fancy restaurant. And when people begin cutting back on spending it causes consumer prices to fall. But those were in the good ol’ days. Now, the economy has gone global and the US Fed no longer controls inflation. Prices are no longer set by America’s 300 million consumers...but by Asia’s three billion consumers.

*** We’ve explained all this many times before. Today, we add a nuance. ‘Decoupling’ is not a fact; it’s just an idea. The United States of America is still the world’s biggest consumer; as it slows, it is bound to have an effect on the world’s markets. China still sells 60% of its output to foreign buyers. And prices are still set at the margin. Watch out for a fall in the price of oil...and food.

And gold? Maybe that too. But oil and food are consumer items. They respond to the laws of supply and demand, as well as to monetary cues. Gold is fundamentally a form of money. It is much less sensitive to economic cycles...and much more sensitive to monetary cycles...than oil or food. Wherever we are in the commodity cycles — we just don’t know — we are probably a long way from the peak of the gold cycle.

*** Leave it to the Irish. When they voted "No" on the Lisbon Treaty, they threw a monkey wrench into the whole European Union project. Now, they are being asked to vote again. And if they don’t approve it this time, they may be expelled from the EU.

For the Irish, the Lisbon Treaty vote was a little like James Joyce’s Ulysses. Almost no one had read it. Those that had read it didn’t understand it. But they were proud of it anyway.

This is what we like about Europe. It is a collection of member states that speak different languages, have different cultures, drive on different sides of the road, and can’t even get together on their fundamental documents. It is as if the American states now had to ratify the Constitution...and Rhode Island voted it down. America would be a better place for it, in our opinion. Because nothing leads to trouble like a strong central government.

Erin go bragh...whatever that means.

*** The big news today: Zimbabwe’s opposition party decided that voting wasn’t worth dying for. A wise decision, in our opinion.

Meanwhile, the British press is making fun of Pillsbury, North Dakota. The reason for the ridicule is simple enough. The town held a municipal election and not a single voter turned up at the polling station — not even the candidates themselves. The town has only 11 people in it, so we can presume there was not much tax honey worth fighting over. If there was influence being peddled, in other words, the price was so low that even the current mayor said he was too busy on the farm to cast a ballot.

That’s the sort of politician we’d like to have running the whole country, one with better things to do than to meddle in other peoples’ business.

Democracy is greatly over-rated. No more entertaining form of government has ever been invented. But it is only entertaining if you don’t take it seriously. When you begin to be earnest about it, the whole thing dissolves into a dark puddle of it humbug, claptrap and bunkum.

The founders of the United States of America distrusted democracy so much they designed a whole government to prevent it. Not once does the word ‘democracy’ appear in the Declaration of Independence, the Constitution, or the Bill of Rights. The Constitution is basically an elaborate restriction on what the voters can do. There are different branches of the federal government, expected to offset each other’s power. And there’s the Bill of Rights itself, limiting the power of the central government — no matter how many people vote.

Of course, all that has been swept away by a long series of subterfuges and scams. Now, the country not only suffers the full plague of democracy itself, it spends hundreds of billions trying to inflict it on the rest of the world. P.S. If you enjoyed this article then we encourage you to sign up for the free Fleet Street Daily eletter. Learn what you can expect from today's markets -- and how to prosper in the face of uncertainty. You won't find more thought provoking writing anywhere on the Internet.

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The Fed Loses Control Of Inflation...

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