The government released the latest inflation data and the results were the worst we have seen in forty years. The retail number came in at 8.4% and the wholesale number clocked in at 11.2%. Of course, the retail number excludes the things that people buy, like food, fuel and housing. These numbers also rely upon the new math rather than old math used the last time inflation was an issue. By the old inflation standard, retail inflation is over 15%.
The political class is poleaxed by these numbers as they have been assured that inflation at these levels was impossible. Modern economic theory says that inflation is caused by too much money chasing too few goods. We now have top men in place to keep an eye out for this. They just need to manage the money supply to keep inflation under control. This assumption led the top men to assume inflation was transitory, the result of supply chain issues.
That should be the first red flag when looking at the economic data. Those top men that are supposed to have a handle on the money supply say they are as surprised as the rest of us that food has doubled in price. A month ago, they were talking about a series of exceedingly small rate hikes. Now they are talking about a series of substantial rate hikes to prevent inflation from going even higher. You get the sense that there is both panic and confusion among those top men.
One reason for this is the long period of historically low interest rates. What the Federal Reserve did forty years ago to tame inflation was remove money from the system by raising borrowing rates. The real creators of money are the banks, who create money through lending. By raising their cost of money creation, they create less money and the result is fewer dollars chasing goods. At its peak in 1980 the 10-year Treasury was going for 15% versus 2% currently.
In other words, getting rates back into the normal range means three or four times the current rates. The world is simply not prepared for such a thing. Think about what happens to the real estate market if rates simply double. Refinancing comes to an end and homes sales collapse. No one is trading out of their home with the 3% mortgage into a home with a 5% mortgage, at least not on purpose. This would be the new reality throughout the financial world.
The other problem with this approach is the massive government debt. The way government handles debt is not like normal people. They issue bonds, pay the holder interest, but never pay them off. Instead, they issue new bonds to pay off the old bonds and the cycle begins anew. Rolling debt like this works as long as the market for new debt looks like the market for old debt. If the Federal government has to start borrowing at two or three times the old rate, it is big trouble.
The other way the Federal reserve can tackle inflation is to sell its massive holdings of equities, treasuries and other assets. The latest balance sheet from the Fed says they are holding about $8 Trillion in assets. They can begin selling which removes cash from the system. Keep in mind that the value of the S&P 500 is about the same as the Fed balance sheet, so this is a powerful option. They added about a trillion in equities during Covid as a way to juice the markets.
