Inflation, Asset and Consumer Prices
“The Fed finds itself between a rock and a hard place: either it keeps inflating or the whole confidence-based valuation of financial assets collapses. Either it raises interest rates or the dollar collapses.”
There has been occasional speculation about what happens to asset values in a hyperinflationary collapse. The basis of the question has recently become suddenly relevant, because consumption in America and Britain has been stimulated with unprecedented monetary inflation aimed at consumers, and been met with limited supply, leading to strongly rising prices across the board.
In short, unless urgent action is taken, the possibility of a hyperinflationary outcome has become a possibility. The only alternative is to stop monetary inflation and thereby deliberately crash the global economy.
Along with other central banks, the Fed is trapped. We will assume that rather than face this reality, governments and central banks will continue with their money printing until both their fiat currencies and financial systems face collapse. All precedent points to this choice.
That being the case, an examination of how a collapse in the purchasing powers of fiat currencies is likely to affect asset and consumer prices is timely. This article draws on theories of money as well as empirical evidence in search of some answers. The answers will surprise and discomfort many of its readers.
It is a common perception that in inflationary times financial and tangible assets afford protection from monetary debasement. Instead of rapidly escalating, so long as the consequences of inflation are contained as they have been since the early 1980s, non-fixed interest investments have been good inflation hedges. But what happens to asset prices if inflation is not contained and escalates?
To answer this question, we must first define what we mean by contained inflation. Interest rates normally put a brake on the loss of a currency’s purchasing power, limiting inflation to a cycle of credit. In other words, the market must be prepared to operate and allow interest rates to function as compensation for the consequences of monetary and credit inflation. Clearly, this condition does not apply today because central banks supress interest and bond rates as well as any evidence of the bank credit cycle. Furthermore, both foreign holders of a currency and its domestic users must be satisfied with monetary conditions to broadly retain their exposure to it. In the case of the dollar, which is the currency that really matters to us all, that has been undoubtedly true so far. But in these times of rising monetary inflation, there will come a point when the lack of interest compensation for currency debasement will begin to overtly undermine the dollar’s purchasing power, and in the first instance this matters particularly to foreign holders.
It is in this context that a deeper examination of the relationship between assets and the accelerated rate of issuance of state currencies is pertinent. That the rate of monetary expansion has accelerated is no secret; but so far, the probable effects on the purchasing power of the dollar, and also for other currencies aligned with it, have been ignored by investors. Central bankers have been coy on the subject, and by fiddling with the price inflation averages statisticians have buried the evidence. The suppression of the evidence on prices has been an important factor in what is effectively a concerted campaign of disinformation about inflation.
While these conditions have built up for decades, so far, non-fixed interest asset values have still afforded protection for investors’ capital. For the middle classes, the values of their homes, often geared through mortgage borrowing, have risen substantially. The values of their portfolios and pension plans have also benefited hugely. For them, these conditions have been extremely beneficial, which is why central banks have latched onto the wealth effect and are now directing new money into stock markets at unprecedented rates through quantitative easing.
The current state of play for both financial and non-financial assets has led not only to rising asset values but is now fundamental to the economic confidence upon which central bank policies entirely depend. But the problem with confidence as a policy is that it assumes that the crowd must be permanently bullish and that reality must never intervene. Policies backed on little more than perpetual hope must fail.
By admitting for the first time that it might lose tight control of interest rates because of rising consumer prices, last week’s FOMC statement has raised fundamental questions about bullish assumptions. For investors, the smoky clouds of hopium began to clear, revealing an FOMC that might lose control over markets. The initial reaction, which is all we have seen so far, is that short term dollar interest rates rose slightly, discounting a possible rise in interest rates being brought forward. Longer-term rates declined slightly, reflecting the anticipated deflationary effect. And the dollar rallied against other currencies, whose central banks are yet to admit that prices in their bailiwicks are likely to rise more than previously expected.
The initial effect on equity, commodity and precious metal prices was to drive them all lower. We will come on to commodities and precious metals later in this article, but equities will hold our attention for now. They have risen to current levels mainly on the back of the Fed’s $120bn monthly QE, targeted at pension funds and insurance corporations. QE encourages these institutions to increase their investment risk profiles from holding US Treasury and agency debt, substituting them with corporate debt and equities.
Part of the investment chatter is about the need for the Fed to taper QE to address monetary inflation, which oversimplifies the situation. If equities are declining into a new bear market, the Fed will stand ready to increase QE to support equities and cap bond yields, because that is the policy: the planners cannot afford to see investor confidence decline and evaporate. We saw this in mid-March 2020, when in response to a decline in the S&P 500 index of fully one third from mid-February, the Fed cut interest rates to zero and increased QE to $120bn monthly.
If the S&P is on the verge of another move downwards, the rescue starts with interest rates at zero and QE at $120bn monthly. Interest rates cannot be reduced from here. We can rule out negative rates on the basis that that would collapse the $4.5 trillion money market fund business, as well as put the whole commodity complex into permanent backwardation from the money side. If anything, interest rates should rise because of the rapidly escalating threat of a fall in the dollar’s purchasing power. That leaves QE. The Fed can do one or both of two things. It can buy directly into index-tracking ETFs, bypassing pension and insurance funds following the policy of the Bank of Japan, and it can increase the monthly quantities from $120bn.
The obvious flaw in this solution is that the way to stop inflation is to cease inflating the quantity of money, not increase it, which is what QE amounts to. But the Fed finds itself between a rock and a hard place: either it keeps inflating or the whole confidence-based valuation of financial assets collapses. Either it raises interest rates or the dollar collapses.
We are at a critical point for equities, illustrated by peak investment sentiment, and there is no better indicator for sentiment than the extent to which investors are prepared to borrow to increase their profits on the bull tack. This is the message from Figure 1, which is clearly shouting extreme greed and a total absence of fear of losses, always associated with an extreme top and an inevitable collapse to follow.
Bullish sentiment is probably higher than we have ever known in our li
Article from LewRockwell