Fed Stimulus Leads to Stagflation

by John Browne, Senior Market Strategist at Euro Pacific Capital

Despite the full onslaught of Keynesian economic policies, including the injection of unheard of sums of printed money into the financial system, state sanctioned accounting tricks, negative real interest rates, massive deficit spending, and debasement of the U.S. dollar, the American economy is slipping back fast towards recession. This week’s release of dismal employment figures, in which the entire economy could only muster 54,000 new jobs, confirms that fact.

It is certainly reasonable to assume that more jobs would have been lost in 2008 and 2009 if the government had not steeped in as aggressively as they had with this Keynesian barrage. But if we had chosen the less interventionist path our present reality may have been quite different. We had the opportunity then to lay the ground work for a real recovery. This was a theme that I continually stressed at the time.  Instead, our leaders chose the time worn strategy of inflation as an economic cure all. It hasn’t worked, and our economy is far worse now as a result.

But the price for these massive injections of cash and the debasement of the currency will be continued economic malaise. There is a word for the ugly combination of recession and inflation: stagflation-the worst of all worlds and the most difficult to cure. I suspect that we will hear this word mentioned much more often as the decade wears on.

The Fed has pumped trillions of synthetic dollars into the economy through purchases of toxic assets from the balance sheets of failing banks. These moves have permitted banks to camouflage other suspect assets under accounting gimmicks, thereby perpetuating a zombie financial system. Not only have most of the struggling banks survived, they are thriving. By dropping short-term interest rates to below the level of inflation, and by receiving interest on the deposits made at the Fed, the banking sector has been extremely profitable over the last few years, especially for those institutions lucky enough to have been designated as “too big to fail.” It is not surprising that Wall Street bonuses continue to flow generously. But these developments hardly benefit the world beyond Wall Street.

By robbing depositors of an economic return on bank deposits, the Fed sought to force consumer demand. However, aware of their massive exposure to derivatives, many related to real estate, the banks remain tight on consumer lending. Further, the Administration has appeared unfriendly to business and has caused great uncertainty over future taxes, regulations and health expenditures. As a result, consumer confidence has plummeted, and rightly so.

As the price of real estate continues to fall, it draws into question the backing of real estate related derivatives, threatening the banks, making credit even tighter, and driving recession even deeper amid rising unemployment. All the while U.S. Government spending still veers out of control. To finance the largesse, Treasury debt has exploded and the Fed has printed money as never before. As a result, the U.S. dollar is approaching all time lows against the many major currencies. If it were not for deep concerns over the continued existence of the Euro, the U.S. currency would have fallen far further.

Some short-sighted economists have lauded the fall of the dollar by arguing that a weak greenback will help U.S. exports. While it’s true that initial stages of currency devaluation can have such an effect, over time a falling currency proves to be both highly damaging to domestic businesses and inflationary for the overall economy. Evidence increasingly shows that American businesses and consumers are facing higher import costs. In other words, do not look for a cheap dollar to provide any meaningful boost.

Clearly the government’s economic prescriptions have failed. That does not mean, however, that their policies will be abandoned. On the contrary, look for policy makers to up the dosage. But when the Fed introduces a third QE program, look for inflation to break free from the narrow ranges that have predominated over the last few years. When that happens, the next phase of the economic cycle will set in. Stagflation will be the order of the day.

Read more at Liberty Maven