I've made a living out of exposing economic fallacies, but there's one whale
that I can't seem to harpoon. Even top-flight Wall Street analysts seem to
believe that the Fed's doubling of the monetary base after the credit crunch
has not had an inflationary impact on our economy.
Their logic can be summed up like so: "The money the Fed created and dropped
from helicopters has all been caught in the trees." In other words, the Fed is
creating money, but it is just being held as excess reserves by the banking
system instead of being loaned to the public. Therefore, the money supply
hasn't truly increased, there is no money multiplier effect, and aggregate
price levels are behaving themselves.
But this is only a half-truth. Yes, most of the money created by
the Fed has been kept by commercial banks as excess reserves. However, the Fed
doesn't conjure reserves by magic. It first creates an electronic credit by
fiat, then purchases an asset held by a financial institution. Those primary
dealers then deposit that Federal Reserve check into their reserves.
The act of creating money from nothing and buying an asset - be it a Treasury
bond or Mortgage Backed Security (MBS) - drives up the price of that asset in
the open market. Those price distortions send erroneous signals to private
buyers and sellers, eventually creating gross economic imbalances.
Therefore, the inflation created by the Fed first gets concentrated in whatever
asset it has chosen to purchase - before spreading throughout the economy.
In the latest example of the Fed's monetary manipulations, chairman Ben
Bernanke & Co purchased US$1.25 trillion in mortgage-backed securities
(MBS). The prices of MBS were therefore driven up (and yields down). Before
that, the Fed forced the entire yield curve lower by purchasing not only
Treasury bills but also $300 billion in notes and bonds. The Fed has also
recently indicated that it will be swapping maturing MBS for longer-dated
Treasury securities in an effort to keep its balance sheet from shrinking.
While it is true that, for now at least, we have been spared the imminent curse
of skyrocketing consumer prices, thanks to the falling money multiplier, it is
blatantly untrue that the trillion-plus dollars the Fed created have been
Not only has the huge buildup in the monetary base put pressure on the US
dollar and caused gold to soar, but it has also broadcast an egregious and
distortive price signal for US debt securities. The 10-year note is now trading
just above 2.5%. That yield is near its all-time record low, nearly 5
percentage points below its 40-year average, and 13 percentage points below its
record high of September 1981.
US sovereign debt should only enjoy such historically low yields due to an
overabundance of savings, low inflation, and low debt. None of those preferable
conditions currently exist.
Hence, US Treasuries are the most over-supplied, over-owned, and over-priced
asset in the history of the planet! Once the debt dam breaks, it will send the
dollar and bond prices cascading lower, and consumer prices and bond yields
through the roof.
While Wall Street and Washington are petrified of the deflation boogieman, the
real menace lurking in the shadows is the Fed's bond bubble - and it's going to
eat small investors alive.
Michael Pento is senior economist and vice president of Managed Products,
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