The Fed has reached the point where there are two choices — Allow the government to shut down or allow itself to be the Treasury’s ATM machine.

Inflation is, as Milton Friedman was fond of saying, “always and everywhere a monetary phenomenon.”  It is insidious. It becomes a part of everyday life, sometimes overlooked. It is cumulative and devastating. The US dollar has lost 96% of its purchasing power since the formation of the Federal Reserve in 1913. Most of that loss occurred from the late 1970s. The US abandoned Gold as backing for its currency in 1971, which left the entire world on fiat currency, unbacked by anything but government promises.

The American worker was clobbered during the past 30 plus years, whether he realized it or not. Today’s real weekly wage is below that of 1966. It has been so since 1977. During the late 1970s and early 1980s inflation was more than insidious, it was blatant. Mortgage rates, the prime rate and inflation rates rose well up into double digits. Inflation then was not some mild background music to life. It was a cacophony. As Reagan described it: “Inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man.”

We are likely now on the eve of an inflation that will make the Carter-Reagan era appear mild. The political class and their actions assure that.

This chart shows rather dramatically what has happened to the Monetary Base. In late 2008, it more than doubled in three months. As of last month, the monetary base had grown to over $2.2 Trillion, a record and almost a tripling in one year! This rate of  growth is unprecedented in this country and has usually preceded hyperinflation in other countries. Were there not mitigating circumstances, one might expect the total money supply and the general price level to triple shortly.

The mitigating circumstances are continued debt contraction in the financial system and the holding of excess reserves by the banks. Both of these factors have thus far dampened the effects of money expansion. These factors are likely limited in their ability to continue to protect in the future. If/when the economy recovers, both of these factors diminish and eventually disappear.

The Fed’s Myths The Fed tries to maintain two myths: 1. they are capable of managing the banking system and the economy, and 2. they are independent of the Federal Government and need to be so. Both claims are at best dubious and more likely laughable. The Fed has no ability to manage the economy, any more than Gosplan, the Central Planning organization of the old Soviet Union, was capable of managing that economy. Reviews of statements by Greenspan or Bernanke show they have little ability to predict where the economy is going, no less steer it. Fed interventions exacerbate economic volatility and cycles. The Fed is unequivocally at fault for the current economic crisis.

Exit Strategy Ideally the Fed had would have an exit strategy that would enable them to extract excess reserves at a rate that offset the banking system’s willingness to lend. The Fed has no strategy, because none is possible. There is no way to determine how much of the reserves are excess (as opposed to being held for asset writedowns expected to come) or when and at what rate the banks will begin to use them for new loans.

The Fed cannot know this information. Thus, like any political entity, they will err on the side of caution. They will wait too long to act, making sure that the economy has truly recovered. This delay will ensure higher inflation, certainly higher than an omniscient being would produce. Regardless, withdrawing the funds will create destabilizing forces in the economy and collapse the malinvestment that has been propped up by monetary infusion. Whether this transition will create another recession, or be interpreted as one, is unknown. The impossibility of managing an exit strategy is not the major problem, however. The real problem is that there can be no exit strategy.

The Treasury’s ATM Machine Regardless of how the Fed’s charter reads and no matter how much the Fed defends its independence, the reality is that the Fed is an arm of the Federal Government.  It is not the dog, it is the tail. It has become the Treasury’s ATM machine, whether it wants to be or not.

The Federal Government is unsustainable. It has liabilities (including the unfunded social promises such as Social Security and Medicare) over $100 Trillion. It has revenues about $2.5 Trillion and spends all of this plus at least another $1.5 Trillion per year. Budgeted programs project these kinds of deficits for ten years and undoubtedly understate reality. These shortfalls are not fundable via open-market Treasury bond or bill sales. Foreigners are withdrawing from funding our deficits. So too are domestic investors. Credit rating agencies are murmuring about downgrades in US Federal debt. Returns have fallen to practically nothing while risk has increased. Why would anyone want to buy our debt?

The Fed has reached the point where there are only two choices — Allow the government to shut down or allow itself to be the Treasury’s ATM machine. In a galaxy far, far away, the Fed, perhaps with Darth Volcker at the helm, might have been able to say: “No More!” Times were different then. Saying no was easier when it didn’t involve bankrupting the entire Federal Government. The ability and willingness to say “No” prevented the government from reaching its current condition. Years of political ingratiation by Greenspan and now Bernanke have brought us to this point.

“No” is unthinkable now. The Fed has become a lap dog for the Treasury. Indeed, Fed purchases of Treasuries is the only way that the government can continue to run. This is why large-number inflation is inevitable. It can be no other way, given Government spending and the unavailability of convential financing. Bernanke and his pygmies warn us about deflation to deflect what they know they must do. For awhile, they hope to dampen inflationary expectations with this diversion.

The debate as to whether this economic crisis ends in either Deflation or Inflation is interesting. Many believe that it ends in both, first a deflationary nightmare, followed by an inflationary nightmare. I agree with this position, but in reverse order. The Fed will not trigger a government bankruptcy by refusing to buy Treasury Bonds. It will continue to monetize the deficits rather than shut down the government. That suggests monetary base growth in the range of  50 – 100% per year for the next several years. The number is likely to be that high (or higher) because, in addition to funding the Federal Government, the Fed will continue to have to buy trash off bank balance sheets.

The continued infusion of money into the economy will accelerate inflation to levels well beyond the 1980 period, perhaps hyperinflation. Eventually, the dollar will collapse, precipitating an international currency crisis. That will be followed by a collapse in our economy as domestic trade freezes. People will refuse to hold or accept dollars. At that point, we will be back to a barter system and a Greater Depression.

Better stock up on goods that can be easily bartered.

To learn more about currency behavior, try experimenting with free forex demo accounts.