A Solitary Kindling Of Inflation In A Lake Full Of Gasoline

People who've read through The $300 Trillion Dollar Crisis may well recall that I mentioned the consequences of the first Quantitative Easing (bailouts) as being both possibly inflationary as well as damaging to the stability of the dollar because of our international trading partner's reactions towards the deluge of US dollars about to reach their shores. Well, it appears that we're beginning to see this in real time now.

I'll delve further into this topic in a different article, but the decisions of the Fed of late are creating a large disincentive toward local lending. Loan companies who were facing bankruptcy from mortgage backed securities not being worthy of the paper they're printed on, all of a sudden had their behinds rescued by our government (and all of its citizens, via an increase in the federal debt) once the Fed consented to purchase those undesirable securities at full par value. Additionally, the Fed opened up a myriad of emergency liquidity channels in an attempt to get the financial institutions lending once more.

However the loan providers may not be really in a mood to give loans to the locals these days. There's a couple of reasons for this. The first one being that they are too busy using that money that they've borrowed through the Federal Reserve to buy US Treasuries, which helps keep the US Treasury auctions running smoothly. (I've got a lot to say about that, but not in this article.) On top of that, the Fed has interest rates so low that the lenders have almost no interest in generating new loans. They simply aren't getting much of a profit. (Many investors are faced with a similar difficulty nowadays.) But...overseas investments tend to be offering much better interest rates right now. Additionally, the currency exchange markets (FOREX) lets them take on trade positions at 100 to 1 leverage, so $1 million in funds are able to control and get the gains from $100 million in currency exchange movement.

On the other hand, aren't a lot of the foreign investments a hazardous gamble ? Won't the more attractive interest rate in, say Ireland, actually suggest that there is a higher probability of default on loans made to them? Yes, but that doesn't matter to the banks. The federal government has now shown to the frat boy executives managing the too big to fail banks that daddy will get them out of any scrape they can get in, and they've got nearly unlimited access to federal funds at a close to zero percent interest rate under the Fed's ongoing ZIRP (Zero Interest Rate Policy) environment, so why not load up with what they can and go out and capture the bigger returns attainable offshore?

Not surprisingly, this method does have some, shall we say, unwanted side effects. This deluge of money originating from our banks towards the FOREX and foreign bond markets is weakening our dollar and strengthening foreign currencies. This may not sound like an issue initially, however it has the consequence of making foreign products more costly to us, and that's not how the game is played. If truth be told, a lot of our overseas trading partners have put in a considerable amount of time and energy making sure that their products will be affordable for you to purchase. In the game, the US plays the bottomless customer, and our strong US dollar is useful just about everywhere, so we buy, they produce and sell, and everyone's happy.

Sterilizing a flood of American money that's more than the typical amount originating from the United States isn't an easy thing to have to do. Many countries are confronted with a number of difficult choices if they wish to keep their balance of trade:

1) They might vault the surplus dollars, which takes those dollars from the overall pool of available money and restrengthens their own foreign money. But they can't spend those US dollars without them becoming active once again, so they are stuck with unspendable dollars. (Suppose that a percentage from your paycheck was put in a non-interest bearing bank checking account, along with the stipulation that if you take it out of the account and then spend it, you'll all of a sudden have a pay cut from your boss.) Moreover, those vaulted money is only good when inflation doesn't nibble away their value, which looks like it's getting increasingly probable considering the present actions from the Federal Reserve and federal government.

2) They can utilize them to acquire United States Treasury notes. It's been the primary means of sterilizing excess money up to now, mainly because of UST's being backed with the full faith and credit of the US. But this option is looking much less appealing right now, due to several factors. The first of which is the extremely low rates that the US is currently paying for those American bonds. They're being forced to compete with those American bankers who are obtaining nearly free loans from the Fed any time they want to buy an US Treasury bond. And in the bond trading world, too many buyers equates to a very low market rate of interest return. Furthermore, since our interest rates are hovering near zero at the moment, the only real direction to go in the foreseeable future is higher, and rising interest rates kill the resale price existing bonds. Looking at this, a ten year bond offering a meager 2.6% annual return rate isn't so appealing right now. More ominously, China appears to have been slowly and quietly selling its extensive holdings of US Treasuries for Euros of late, leading some to think that a race for the exits could potentially be in the future, which would end up being disastrous for anyone left holding those bonds.

3) They could print their own currency, and use it to buy US dollars, which in essence fights the fire of of late created dollars by the us government with the fire of their lately created money. Not surprisingly, if the us is allowed to simply whip up a large amount of money, why shouldn't they be able to as well? This is apparently the least unpleasant option for quite a few countries right now, and is in fact at the heart of the "currency manipulation" that the US is now accusing several countries of doing. On the surface, it seems optimal. It accomplishes the desired result of revaluing the overseas nation's currency without requiring them to vault American dollars or buy US Treasuries.

However, there's one little downside to this. You see, all the extra money put out by both the US and by our trading companions is going to find someplace to land. It already tried to land by affecting the trade balances and forcing the US to shell out more for foreign goods, but that was countered, so now it's seeking another place to be of use.

My personal opinion is that this extra money is going to find it's home with the commodities markets. Items like crude oil, copper, gold, silver, palladium, as well as other useful goods that are necessary to making nearly everything else are likely to experience a surge of their prices, and in certain cases already have. Each and every newly created foreign currency note out there represents American dollars that weren't removed from the market via other methods, and that dollar sterilization system is vital to holding the inflation rate of real goods at bay. So, the rest of the world has the option of either choosing a hit to their income in order to bury those added American dollars, or sharing in the worldwide inflation that's currently being generated as all of those additional dollars begin to bid up commodities prices.

Oil is easily the most likely target for this hit, due to it's use within nearly every other manufacturing system. And oil is also different in it's capacity to transmit price inflation throughout an economy, due once again to its widespread utilization. Currently, OPEC is looking at a price hike for their oil to $100 per barrel, and the market may have even more severe ideas as to what the price should be.

The different bailouts from recent years are coming back to us soon, and with the government making some significant noises in regards to requiring more, things are just going to become worse in the mid-term. Personally, I think we've now left the land of low inflation, and are running headlong directly into "inflation alley" at ever higher speeds.

NOTE: This article is intended to be editorial in nature, and is not intended to impart investment advice.

I personally invite you to come over to my blog, The Rogue Economist, or check out my online E-Book, The $300 Trillion Dollar Crisis,