Inflation Mosaic

• Recent money printing exceeds 2.5 times the combined costs of our recent wars. It’s ginormous.
• Compounding the money printing problem, US debt cannot be paid, not even in inflated dollars.
• Serious inflation is inevitable that will crash stock and bond markets, in addition to devaluing the dollar.

Three years ago I wrote Per Capita World Debt Has Surged To More Than $200,000 which is one of my most-read articles. Many of the comments posed money printing as the solution. Just pay the debt with inflated money. 

In the following, I explore the practicality of settling the debt with newly printed money. We’re poking the inflation bear now but haven’t made a dent in the debt simply because there’s way too much of it.

Where we are now

The official US debt of $27 trillion is 130% of GDP but Professor Lawrence Kotlikoff has warned about the “off-balance sheet debt’ for Social Security and Medicare that totals another whopping $76 trillion. All-in US debt is $103 trillion, which is 490% of GDP. 

Can the government realistically print $100 trillion? In theory, the government can print all it wants, but it needs to stop when all that money causes “serious” inflation. There is a limit to how much money can be printed, and it seems that we’ve reached it.

Money is “printed” when the Treasury issues bonds. If these bonds do not clear the market, the Federal Reserve buys them. Lately, the Federal Reserve has been buying most of the Treasury’s new issues. 

Money printing and the US debt

Starting with quantitative easing (QE) in 2009, the US government has printed $16 trillion through 2022 so far. This has caused inflation to become “serious” at 8.5% and rising. 

The inflation bear has been poked and it’s furious. The following picture puts $16 trillion in perspective.

A $trillion is a lot of money. $16 trillion is ginormous. 

According to CNBC :     

• If you paid out $1 per second, to settle a $1 million debt would take less than 12 days. To pay off $1 billion would take 32 years. Paying off $1 trillion at a dollar per second? 32,000 years.
• A trillion is a 1 followed by 12 zeros, like this: 1,000,000,000,000.
• A trillion square miles would cover the surface of 5,000 planet Earths.
• A trillion people would be 10 times more than have ever lived (based on the Population Reference Bureau’s very rough estimate of 108 billion humans ever).
• A trillion dollars is enough to give $3,195 to every man, woman, and child in the United States. (Author’s comment: we actually got this helicopter money doled out in bigger checks)
• For a typical U.S. household, making $50,000 per year, to earn enough to pay off a $1 trillion debt would take 20 million years.

So now the mission is to fight the inflation that this money printing is causing because it will wreak havoc (maybe even hyperinflation) if left unabated. 

The Federal Reserve to the rescue

The irony is that the Fed has been charged to fight the problem it helped to create. As cowboy wisdom advises “When you find yourself in a hole, stop digging.” The Fed has been manipulating bond prices in order to keep interest rates low, executing its Zero Interest Rate Policy, ZIRP. Now it will have to “taper,” meaning it will allow interest rates to increase.

Rising interest rates are bad for stock and bond markets. Unmanipulated interest rates average 3% above inflation, so 11% in an 8% inflationary environment. A 9% increase from 2% to 11% will cause bond prices to plummet 54% because duration is 6.

Stock prices will also fall because security analysts will discount future earnings at higher rates. That’s what happened in 2013’s Taper Tantrum. Stock prices fell in response to tapering, so the Fed backed off. But this time backing off will fuel the inflation fire that the Fed is supposed to extinguish. The following chart details the problem. The Fed is in a corner.

Some say the Fed will opt to maintain ZIRP, allowing inflation to soar. Which do you think the Fed will choose, controlling inflation or controlling interest rates? It can’t do both.

Bursting the stock market bubble

Although many have tried, no one has successfully explained why the US stock market has soared to unprecedented levels -- extremely expensive by any measure. But Crestmont Research has documented the necessary level of inflation to sustain high stock prices. 

Inflation has to be near zero in order to have high Price/Earnings, as shown in the following image. The implication is that fear takes hold when inflation is at extremes, either high or low, so investors are unwilling to pay a premium for future earnings.

High inflation will burst the stock market bubble

Topsy Turvy model portfolios

We’ve all heard the investment manager commercial “You deserve a tailored portfolio, not a cookie-cutter strategy.” And you probably thought to yourself that this was disingenuous since this manager does what every manager does -- match you up to an off-the-shelf model. 

Most, if not all, money managers and consultants use model portfolios, and most use bonds to limit risk. Low-risk models hold a lot of bonds and high-risk models hold a lot of stocks. 

In the next few years, as interest rates rise and bond prices fall, low-risk models will occasionally lose more than high-risk models when bond prices fall more than stock prices. Model portfolio performance will be topsy turvy, disappointing investors.

Target date funds (TDFs) will disappoint too, with near-dated funds losing more than long-dated ones. Funds for those near retirement are supposed to protect, but they won’t.

The problem is that bonds will not protect for the foreseeable future. To solve this problem, model and TDF developers will need to replace bonds with safe assets like T-bills and TIPS  (Treasury Inflation-Protected Securities). The Federal Thrift Savings Plan (TSP) for example uses a government-guaranteed G Fund instead of bonds in its TDFs. 

Model portfolio providers, TDFs, and TAMPs (turnkey asset management providers) will be slow to make this move to safety and most will never make the change, opting instead to suffer along with competitors.

Challenges create opportunities. New and better models, and model providers, will appear.

Conclusion

Buddha said, “Impermanence is eternal.” The world is always changing. The stage is set for rising inflation that will force up interest rates, and rising interest rates will burst the current stock market bubble because something has to burst it. 

A stock market correction is more than 7.5 years overdue.

In the current Thucydides Trap China could get the last laugh if the US dollar loses its status as the world’s reserve currency.  

Most of our 78 million baby boomers are in the Risk Zone spanning the 5 years before and after retirement when investment losses can irreparably ruin the rest of life. They are especially vulnerable to what lies ahead so they need to protect now against losses and inflation with assets like TIPS, commodities, precious metals, and the like. If they are invested in TDFs, they need to get out because they are not safe.