The natural tendency of government, once in charge of money, is to inflate and to destroy the value of the currency. To understand this truth, we must examine the nature of government and of the creation of money. Throughout history, governments have been chronically short of revenue. The reason should be clear: unlike you and me, governments do not produce useful goods and services that they can sell on the market; governments, rather than producing and selling services, live parasitically off the market and off society. Unlike every other person and institution in society, government obtains its revenue from coercion, from taxation. In older and saner times, indeed, the king was able to obtain sufficient revenue from the products of his own private lands and forests, as well as through highway tolls. For the State to achieve regularized, peacetime taxation was a struggle of centuries. And even after taxation was established, the kings realized that they could not easily impose new taxes or higher rates on old levies; if they did so, revolution was very apt to break out.-Murray N. Rothbard
The rampaging bullmarket here and abroad has raised concerns that recent increases in nominal interest rates could put a kibosh to the current run.
As I pointed out before, the actions in the interest rates markets will be shaped by different circumstances[1] which means it is not helpful to apply one size fits all analysis to potentially variable scenarios that may arise.
Interest rates may reflect on changes in consumer price inflation, they may also reflect on the perception of credit quality and they may reflect also on the state of demand for credit relative to the scarcity or availability of savings or capital[2].
Since the current interest rate environment has been mostly manipulated by political actions, where the political goal has supposedly been to whet aggregate demand by bringing interest rates towards zero, then we are dealing with a policy based negative real rates economic environment.
So the crucial issue is, has the recent selloff in treasury bonds neutralized the negative real rates regime? The answer is no.
First of all, current environment has not been reflecting concerns over deterioration of credit quality as measured through credit spreads[3], which seem to have eased.
Also, milestone highs reached by global stock markets, led by the US, have encouraged complacency through a reduction of volatility[4].
Second, the yield curve of US treasuries despite having flattened (perhaps due to policy manipulations) still manifests opportunities for maturity transformation trade or lending activities.
Thus, we are seeing signs of recovery in business and commercial lending in the US.
Some of the banking system’s excess reserves held at the US Federal Reserve seem to be finding its way into the economy.
Lastly, many are still in denial that inflation poses a risk, despite rising Treasury Inflation Protected Securities (TIPS).
TIPs are government issued treasury securities indexed to the consumer price index (CPI) with maturity ranging from 5 to 30 years which are usually considered as inflation hedges. (That’s if you believe on the accuracy of the CPI index. I don’t)
TIPs seem to have converged with the S&P 500.
Financial markets could be pricing in a risk ON environment and real economic activities, calibrated by the current negative real rates regime, combined with signs of escalating consumer price inflation.
The reality is that mainstream and the political establishment will continue to deny that inflation exists, when the US Federal Reserve has already been rampantly inflating.
Monetary inflation is inflation. However the public is being misled by semantics of inflation by pointing to consumer price inflation.
As Professor Ludwig von Mises wrote[5],
To avoid being blamed for the nefarious consequences of inflation, the government and its henchmen resort to a semantic trick. They try to change the meaning of the terms. They call "inflation" the inevitable consequence of inflation, namely, the rise in prices. They are anxious to relegate into oblivion the fact that this rise is produced by an increase in the amount of money and money substitutes. They never mention this increase
They put the responsibility for the rising cost of living on business, This is a classical case of the thief crying "catch the thief." The government, which produced the inflation by multiplying the supply of money, incriminates the manufacturers and merchants and glories in the role of being a champion of low prices. While the Office of Stabilization and Price Control is busy annoying sellers as well as consumers by a flood of decrees and regulations, the only effect of which is scarcity, the Treasury goes on with inflation.
That’s because any acknowledgement of inflation would put to a stop or would prompt for a reversal of the Fed’s accommodative policies. And considering that the banking system has been laden with bad loans, and that welfare based governments have unsustainable Ponzi financing liabilities, then tightening money conditions, expressed through higher interest rates, means the collapse of the system.
Underneath the seeming placid signs of today’s marketplace have been central banking steroids at work as the balance sheets of major economies have soared to uncharted territories[6].
The US Fed and the ECB, as well as other central banks, including the local BSP, will work to sustain negative interest rates environment, no matter any publicized rhetoric to the contrary. There may be some internal objections by a few policy makers, but all these have signified as noises more than actual actions. The politics of the establishment has drowned out any resistance as shown by central banks balance sheets.
One must remember that the US Federal Reserve was created out of politics[7], exists or survives through political money and will die through politics. And so with the rest of central banks.
Thus there is NO way that central bankers will not be influenced[8] by political leaders, their networks and by the regulated. Political power always has corrupting influences.
A good example can be gleaned from Independent Institute research fellow Vern McKinley’s comments[9] on U.S. Treasury secretary Mr. Timothy Geithner’s recent Op Ed[10]
He recounts how the CEO of Bear, with his firm on the brink of bankruptcy, came to him looking for a shoulder to cry on. From his then leadership perch as president of the New York Fed, the bank ultimately extended nearly $30 billion for a bailout, the first in a series of such interventions.
Central bankers are human beings. Only people deprived of reason fail to see the realities of government’s role.
And since the FED has unleashed what used to be a nuclear option, other central banks have learned to assimilate the FED’s policy. This essentially transforms what used to be a contingency measure into conventional policymaking.
As been said before, inflationism has produced an unprecedented state of dependency
And that such state of dependency can be seen through the dramatically expanding role of non-market forces or the government.
As Harvard’s Carmen Reinhart observed in her Bloomberg column[11],
In the U.S. Treasury market, the increasing role of official players (or conversely the shrinking role of “outside market players”) is made plain in Figure 3, which shows the evolution from 1945 through 2010 of the share of “outside” marketable U.S. Treasury securities plus those of so-called government-sponsored enterprises, such as the mortgage companies Fannie Mae and Freddie Mac.
The combination of the Federal Reserve’s two rounds of quantitative easing and, more importantly, record purchases of U.S. Treasuries (and quasi-Treasuries, the government-sponsored enterprises, or GSEs) by foreign central banks (notably China) has left the share of outside marketable Treasury securities at almost 50 percent, and when GSEs are included, below 65 percent.
These are the lowest shares since the expansive monetary policy stance of the U.S. regularly associated with the breakdown of Bretton Woods in the early 1970s. That, too, was a period of rising oil, gold and commodity prices, negative real interest rates, currency turmoil and, eventually, higher inflation.
This is not an issue involving economics alone. This is an issue involving the survival of the current state of the political institutions.
Bottom line: Rising interest rates will pop the bubble one day. But we have not reached this point yet.
Again, the raft of credit easing measures announced last month will likely push equity market higher perhaps until the first semester or somewhere at near the end of these programs. Of course there will be sporadic shallow short term corrections amidst the current surge.
However, the next downside volatility will only serve as pretext for more injections until the market will upend such policies most likely through intensified price inflation.
[1] See Global Equity Market’s Inflationary Boom: Divergent Returns On Convergent Actions, February 13, 2011
[2] See I Told You Moment: Philippine Phisix At Historic Highs! January 15, 2012
[3] Danske Bank, The US bond market finally surrendered, Weekly Focus March 16, 2012
[4] See Graphics: The Risk On Environment March 14, 2012
[5] Mises, Ludwig von 19 Inflation Economic Freedom and Interventionism Mises.org
[6] Zero Hedge, Is This The Chart Of A Broken Inflation Transmission Mechanism? March 13, 2012
[7] See The US Federal Reserve: The Creature From Jekyll Island, July 3, 2009
[8] See Paul Volcker Warns Ben Bernanke: A Little Extra Inflation Would Backfire, March 16, 2012
[9] McKinley Vern Timothy Geithner's Bailout Legacy Not One To Be Proud Of, Investor’s Business Daily March 15, 2012
[10] Geithner Timothy Op-Ed: ‘Financial Crisis Amnesia’ Treasury.gov March 1, 2012
[11] Reinhart Carmen Financial Repression Has Come Back to Stay, Bloomberg.com March 12, 2012
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