In the middle of July the stock market finally awoke from its QE-induced coma
and realized the Federal Reserve's tapering, which has been going on for the
last six months, was for real. Like a child, who becomes accustomed to a parent
that threatens punishment but never follows through, the market had been in
denial to the Feds withdrawal of monetary stimulus. But now, thankfully, the
ending of Fed asset purchases will be the pin that pops this QE-inflated market
and economy. But please do not confuse the end of QE with the Fed actually
fighting inflation and selling trillions of dollars' worth in Treasuries and
mortgage backed securities (MBS)...because that will never happen.
The Fed has increased its balance sheet by an unprecedented $3.5t since 2008.
They accomplished this by purchasing Treasuries and MBS from banks in exchange
for Fed credit. A credit from the Federal Reserve is a nuanced way of saying "new
money". This new money is transferred as a credit to the banks with the idea
that the Fed can and will reverse this transaction at its discretion. Like
an army releases reserves, the Fed (with the help of private banks) has marched
many of these new dollars into the economy to "save us" from deflation. Once
the job is done, the Fed intends to call these dollars back and shrink its
balance sheet back to pre-crisis levels. This all sounds great in theory, but
as we will soon see, the practical applications of shrinking the Fed's massive
Balance Sheet has become impossible without creating a monetary depression.
For the past few years, the central bank's credit and inflation has been predominantly
deployed in bonds, real estate and equity assets. However, recently this new
money has leaked into the government's manipulated CPI calculation. Therefore,
our government can no longer promulgate the lie that inflation is some elusive
goal that it cannot achieve. And, the argument that stronger economic growth
is around the corner in a context of low inflation has been fully debunked.
That is why the market sold off last week. In a word, it is inflation. The
Employment Cost Index (ECI) component in the GDP data put the Keynesians on "high
wage inflation alert".
But, most will be blindsided by the temporary period of deflation that will
result from the end of the Fed's massive asset purchases, as the monetary spigot
for the primary beneficiary of the Fed's credit--namely stocks and bonds--gets
turned off.
Similar to the housing market in the mid-2000's, we are about to relearn the
lesson that many equity investors (especially those on margin) can only afford
to hold on to an asset when prices are rising.
However, on the other end of this cyclical period of deflation, lies a period
of inflation that will make the '70s seem like an era of hard money. The reason
for this is in order to fight inflation the Fed will have to bring home trillions
of those "money troops" it sent into the economy. Calling the money back is
going to be far more difficult than it was deploying it.
When the Fed buys Treasury debt, most of the interest payments made go back
into the government's coffers. In fact, by law the Treasury has claim to all
income derived from the Federal Reserve; less expenses. So the Treasury pays
the Federal Reserve an interest payment and in return receives most of that
payment back. This is a pretty good deal for the Treasury, considering the
Fed's profit is in the neighborhood of $91 billion a year. This means the Treasury
not only didn't have to find a real buyer for the newly issued debt but it
also did not have to worry about paying interest on that debt.
But, it gets even better--as the bonds mature, the Fed has been rolling over
the principal. Therefore, it is as if the $2.4 trillion of newly issued Treasury
bonds sold to the Fed since 2008 don't even exist. The Treasury gets reimbursed
on its interest payments and never even had to worry about what the cost would
be for the private market to purchase that debt. To further sweeten the pot,
the Fed has pushed rates down to unprecedented lows, leading to relatively-modest
debt service payments on all of its record-breaking $17.6
trillion of outstanding debt.
However, if the Fed wants to genuinely fight inflation, it will have to eventually
raise interest rates. Ending QE will only provide temporary relief from a weakening
currency. To accomplish this in sustainable fashion it will have to shrink
its balance sheet back to around the same level it was prior to the Great Recession.
How does the Fed shrink its Balance Sheet? As we discussed, when the Fed purchases
a bond from a bank it creates a credit that can be taken back at the Fed's
discretion. Taking the credits back on a short-term basis is called a reverse
repo--the Fed sells the assets back to the banking system and takes back the
cash for a very limited period of time.
But, it just cannot conduct reverse repos to the tune of trillions of dollars
without putting extreme pressure on the market for private short-term loans.
This means the government is not only going to have to permanently sell the
over $2 trillion in bonds into the market, it will have to start paying real
interest on that debt as well. And, the private market will also have to finance
all the new annual deficits, which will no longer have the luxury of a trillion
dollar plus annual QE program from our central bank.
The net effect of all this would be surging interest rates and a complete
economic collapse. This is why I do not expect the Fed's balance sheet to significantly
contract for many years, if at all. And predict inflation will become a huge
and growing problem--especially after the central bank launches another massive
QE program in 2015 to re-inflate falling stock prices.
Our government is in a horrific trap because of the record amount of debt
it has issued and allowed the central bank to monetize. This is why every time
the Fed tries to fight asset bubbles and bring inflation under control it will
result in the creation of a monetary depression. And is also why nearly every
central bank on the planet has decided the only real long-term objective is
to fight against deflation and ensure inflation will always prevail.
Michael Pento is the President and Founder of Pento
Portfolio Strategies and Author of the book "The
Coming Bond Market Collapse."