Why the Dollar Will Remain Relatively Strong and Hyper-Inflation is Not an Issue in 2009

Europe’s stance
On the 30th Day of the Investor held in the Netherlands, there was no reason to fear for inflation in the forthcoming two years, according to Han de Jong, Head-economist of ABN-Amro. Along with the collaborating Central Bank efforts in Europe, Asia and the United States, the current crisis is not expected to evolve in a Great Depression that we saw in the early 1930’s.

Seen from perspective, probabilities are indeed low and the differences are clear;
• Policy makers are collaborating instead of embracing protectionism policies
• No significant currency devaluations expected…
• Major banks are not allowed to go bankrupt
• Government stimulus packages are injected to boost domestic economies

The populace accepted consensus is that the current economic stimulus measures are hyper-inflationary. Indeed this would be the case when money is simply ‘printed’ into the real economy. However, it should be clear by now that a significant deflationary force is present in the private sector and ultimately this is withholding inflation from running wild. Budget deficits of the individual nations are controlled to some responsible portion of their respective Gross Domestic Product (GDP). The European Central Bank (ECB) has its target inflation rate set at 3 percent of GDP and is moderate in implying sanctions towards its EU member countries that cross the threshold. As expected, chairman Trichet is unwilling to let inflation run wild. Overnight rate stands at 2.5 percent, as I write.

US policy
The Federal Reserve (FED) is continuing to maintain aggressive policy by artificially tax their (creditworthy) citizens by expanding the FED balance sheet almost 200 percent to $1.6+ trillion since September in relation to the $850 billion at the beginning of 2008. Not all of that capital has yet been flowing into the ‘real economy’ as you can see by selecting the hyperlink below. The light-blue base of the chart shows the actual currency in circulation. FED liabilities chart

The amount of dollar currency in circulation increased by approx. 10 percent. The rest of the money ‘printed’ is hold by the FED in an attempt to avoid immediate hyperinflation. Until now, the deflationary outflow of capital from the private markets is considerably larger than the inflow of consumer credit, hence the continuous lowering of the target interest rate to 1 percent (from 5,25% on Sep. 2007) to stimulate corporate and consumer lending. So far, prices in T-bond market are soaring, with yields at zero and negative percentages for near-maturing bonds. Given the fact that investors are willing to park their money in treasuries at zero/negative bond yields, is currently predicting monetary deflation. Together with the ‘official’ CPI number, investors are actually losing real money in short-term bonds. Not even considering the extremely low yields for 30-year bonds from Treasury. Thanks to the FED, we have a new bond-bubble to collapse soon.

In my humble view, the FED is very anxious about monetary deflation and sequesters dollars to put in use when the overnight rates approach zero percent to counter the contracting money supply. The FED controls this inflationary weapon effectively for as long as needed until normal credit lines to consumers are restructured once again. There are balancing forces on each side of the equation. As long as the monetary velocity (basically, the speed of exchanging money in the financial system) remains low, there is no inflation to be seen anywhere. Not for as long the economy is contracting and consumers refuse to invest, borrow and spend.
You can't just look at the current money supply and pin down the prospects of future rampant inflation without considering that the Fed can pull back liquidity from the banking system before money velocity picks up again.

Creditors and debtors
From a debtor’s standpoint, inflation isn’t all that negative. As the money supply grows, each nominal dollar value declines in terms of the goods or services it can buy. The debtor can count on inflation to erode purchasing power over the life of a loan or mortgage and have the ultimate effect of decreasing their debt load in real terms. Debtors love this effect of inflation. Unfortunately, with Americans generally becoming a nation of inherent debtors, it is not surprising that politicians are almost all pro-inflation since debtors make up most of their constituency, government included. Creditors, on the other hand, count inflation as true evil. Over the life of a loan that a creditor grants to a debtor, inflation weakens the dollar and causes the creditor to be repaid in dollars worth less than the initial nominal value of the loan. Therefore, inflation robs real wealth from creditors. In the current environment this affects US foreign creditors in particular.

Manipulation of dollar and gold
The Fed, as a private institution, has no obligation to report to Congress. In that way they can do whatever they want they think is right. Ben Bernanke knows all about printing dollars, and he shows how good he is at that. But you’ll have to give him more credit, because Bernanke does more than simply levering the printing press.
The Fed intends to feed money into the system, but at the minimum rate needed to possibly prevent the DOW index from staying under 8,000 for any significant period of time, therefore not triggering US banking laws that force banks to start selling and become insolvent. The FED consumes all those newly printed dollars ($1.2 trillion and rising), until the US Treasury has finished the major part of its funding activities at the lowest rates possible combined with a (temporary) strong dollar face value. Lowering the rates is done by buying back maturing short-term Treasury bonds and bills. This lowers the short term interest rate (in addition to the FED overnight lending rate) and indirectly lowers the middle to long term (mortgage) rates at the same time.

To learn more about all the government intervention techniques, I urge you to read this great article from James Conrad at Seeking Alpha. There Mr. Conrad has written a terrific piece, with the upmost correct vision about the intervening policies around the dollar and gold in which I strongly believe is unfolding today.

I would like to conclude with some food for thought;
After this massive deleveraging cycle, whether we avoid monetary deflation or hyperinflation, chances are we’re going to see a new type of financial system. Banking will become boring again. New regulations will allow banks to limit their leverage in the future. When you think about the effects of deleveraging, you must also think about stock valuations. Think about it. Stocks aren’t as cheap anymore as they appear to be. Stocks seem to be cheap at the moment, but are they really? Stocks are cheap when valued within the context of a financed economy once dominated by leverage, low interest rates and low corporate taxes. Those traditional days are over.

By Rob de Graaf