If the recent performance of equity and bond markets is any guide, this view dominates investor thinking. Since the financial crisis eight years ago, the rise in equity markets had been driven by ZIRP and the expansion of credit aimed at financial assets. Now equities are on firmer ground, but this is a view that completely ignores the monetary flows upon which asset values depend. The reason asset values are at current levels is because there has been an excess of monetary inflation over that absorbed by the non-financial economy. Furthermore, demand from non-
The emphasis is now due to swing from monetary towards fiscal stimulation. Instead of money being bottled up in financial assets, it will begin to flow out of them into spending and employment in non-financial sectors, as well as into government, whose budget deficit will rise. The consequences of these monetary flows cannot be
The price inflation killjoy
The effect of redirecting monetary resources previously inflating financial assets into non-financial sectors will be to increase consumer prices. Price inflation shifts, deflating assets and inflating consumer prices, developing a momentum of its own. We have already seen significant increases in dollar prices for industrial materials and energy in 2016. To this we must add the marginal price effect of increased demand for goods and services in a capacity-constrained economy. As products become relatively scarce compared with freely available money, the underlying price dynamics will become dramatically apparent.
The effect of price inflation is not, as commonly supposed, to drive up prices. Instead, it drives down the purchasing power of expanding government-issued currency. And in addition to these supply and demand considerations, there is the added dynamic of changes in consumers’ overall desire to retain money balances, relative to owning
Fortunately for all governments bent on monetary debasement, the public’s understanding of money is limited to it being the objective element in any transaction, and in
The dollar’s accelerating loss of purchasing power could become a significant danger in
And that’s the problem. Mindful of the debt overhang, unless it is prepared to collapse the economy, the Fed cannot raise rates by much, perhaps 2% from current levels at most. If inflation measured by the CPI goes to over 4%, the general level of prices will almost certainly be rising by well over 10%, because the CPI statistic is designed to under-record price inflation by a considerable margin. While the rate of price increases is stable, it has not been an issue, but if it begins to rise, markets are likely to begin discounting higher rates of price inflation and become increasingly aware that the Fed is powerless to act.
In addition to the monetary flow problem discussed above, rising interest rates will therefore become an additional negative factor bearing down on asset values. We can expect the yield curve to steepen as well, and for the long bond to head towards 5% yields and more. Equities and property prices cannot rise in this environment, and must fall.
Gold
This year, bulls of precious metals have ridden a roller-coaster of hope followed by disillusionment. Much of the frustration has been due to the bullion banks seizing the opportunity presented by a strong dollar to force closure of their short positions on Comex. Meanwhile, for hedge funds, short-term positioning in gold has been an easy way to play the strong dollar, which is why money-managers morphed from earlier bulls to a mixture of bears and don’t-knows. Next year is shaping up to be an entirely different matter.
As discussed above, the defining economic feature of 2017 is almost certain to be increasing rates of price inflation and interest rates that are unlikely to rise by enough to stop it, without triggering a debt crisis. These are precisely the conditions that will
Since December 1969, even a strong yen has lost over 90% of its value measured in the one form of money which is no one’s liability. The worst performers
Bear in mind that in a sound-money environment the general price level will tend to fall, reflecting the rising living standards resulting from economic progress. Putting short-term volatility to one side, gold is therefore a far better measure of currencies’ loss of purchasing power than government inflation measures, even if they could be truly accurate.
The 1970s was the worst decade for currency debasement, and the conditions that prevailed at that time look like being repeated now. The principal difference is there was less debt in the private sector, and it needed a large hike in interest rates to swing consumer preferences back into holding government-issued money. The next chart shows Volcker’s inflation-killing interest rate hike at the end of that decade, followed by the subsequent interest rate peaks that were required to stop credit cycles from degenerating into escalating price inflation.
The dotted line, which marks the Fed Funds Rate at the declining peaks of US credit cycles, is currently at an FFR of 2.5%, which has fallen from 5.3% in the first half of 2007, when the last financial crisis began. By the end of 2017 it will be at 2.25%. The reason the line is declining is that total debt outstanding is continuing to escalate, with a growing proportion of it
These strains are also acute in Europe, where the banks are less adequately
The central banker’s response to the inevitable forthcoming crisis, wherever it arises first, is certain: throw yet more money at the problem. After all, it worked following Lehman, there is no alternative solution, and the central banks’ overriding priority is to keep the show on the road.
In 2008/09, the financial crisis was initially confined to identifiable banks and institutions in the US housing market. Next time, when a financial crisis occurs, the problems will be more widespread, encompassing bond markets, property, equities and governments themselves. It will be
These are not forecasts, but an expectation of how events will unfold. Anyone who makes financial and investment forecasts fails to understand the nature of money, money flows and prices. But I can come up with my current expectations for 2017, on the understanding that my expectations today will evolve as events unfold. With that caveat, the following table
It could turn out worse. The conditions faced by America today have many parallels with those faced by the UK in 1972, too many for comfort. At that time, equities peaked and subsequently fell over 70%. From equity peak to financial crisis took nineteen months and the bear market in equities lasted 31 months. The Bank of England was forced to raise its base rate from 5% to 13% by late-1973, which triggered the commercial property crisis. The effect on sterling is recorded in the first chart in this article.
Happy Christmas to one and all, and may we all survive 2017 without too much financial distress.
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