With His Flawed 'Exit Strategy,' Bernanke Has Set the Stage for Stagflation

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By Martin Hutchinson
Contributing Editor
Money Morning

As the U.S. and global economies stabilize, economists wonder how U.S. Federal Reserve Chairman Ben S. Bernanke will manage to reverse all the monetary stimulus that has been infused into the economy over the past year and prevent inflation.

My guess is that he won't be able to do so, meaning investors need to position themselves now for the "stagflation" that's almost certain to come.

Let me explain how I believe this will all play out.

In Federal Reserve's Monetary Policy Report to Congress – as well as in an op-ed piece

in The Wall Street Journal – Bernanke acknowledged the potential danger inflation poses and outlined an "exit strategy" that described a "smooth and timely" withdrawal of monetary stimulus.

However, the Fed chairman was vague about exactly how he will know when to implement that strategy, and the reality is that the exit may be much more difficult to execute than Bernanke portends. Moreover, political pressures are likely to delay any exit attempt until it's too late.

That means only one thing: There is major inflation ahead.

Bernanke believes that the $1 trillion the Fed has added to the monetary base makes little difference because the banks are just sitting on their extra reserves. In recent months, that belief has been right. Bank loan volume has been trending downward since December.

But loan demand always falls in recessions and the 1970s proved that you can, indeed, combine recession and rising inflation – the messy and hard-to-fix malaise known as "stagflation." So Bernanke's remedy of paying interest on bank reserves – thereby reducing banks' desire to lend – may be irrelevant to the real problem at hand.

Global commodities prices are a much better indicator of future inflation, and they have been rising at a brisk clip since the spring.

Bernanke made his name as a Great Depression expert and he tries to fit everything into that template. When the first problems appeared in 2007, he saw the ghost of 1930, when the Fed contracted money supply even though prices were falling. So even though the economy was then overheating, he dropped interest rates fast. That caused oil prices to double in less than a year, making the eventual global recession much worse. 

Bernanke's recent statement that this downturn might be "worse than the Great Depression" reflects his obsession. We don't have unemployment of 25%, gross domestic product (GDP) hasn't fallen by a quarter, and prices haven't fallen by a third.

Now Bernanke's worried that we may repeat the second 1930s recession, that of 1937-38. He sees the cause of that as having been the Fed's increase of bank reserve requirements in November 1936, which reduced the money supply. But that was only part of the problem (banks were by that stage very conservative lenders, anyway). There were two much more likely causes of the 1937-38 downturn.

The 1935 National Labor Relations Act, or the Wagner Act, hugely increased union power, pushing up costs in the auto industry as the United Autoworkers (UAW) took control of that indusry's work force. And the 1935 Social Security Act sucked money out of the economy, as the system took in premiums from 1937, but paid pension benefits only from 1940.

Bernanke's 1930s obsession may well prevent him moving fast enough when inflation reappears. The economy will still be in recession, so he will fear that a tighter monetary policy could cause a "double dip" downturn.  He fears deflation much more than inflation so inflation figures will be massaged and argued away for months while rising prices get a firm economic foothold. Even when the Fed starts tightening, it will do so much too feebly. After all, inflation is already running at well over 2%, so real short-term interest rates are sharply negative.

The other factor that will keep Bernanke from acting against inflation is the federal budget deficit. A deficit that equates to 13% of gross domestic product in 2009 and 10% of GDP in 2010 will be much too high to be financed easily. At the moment, the Fed is buying up to $300 billion of U.S. Treasury bonds to help the U.S. Treasury's funding program. That's directly inflationary, because it's printing money to fund the deficit.

However, the large deficits and the threat of inflation are likely to cause a sharp upward move in Treasury bond yields. That will cause a crisis in the bond market, which Bernanke will try to solve by buying more Treasuries, thereby printing more money.

You see the problem? Bernanke's "memory" of the 1930s and the U.S. Treasury's funding needs will combine to block the "exit strategy" for a long time. There is no "smooth and timely" exit from the money problem, and no way to avoid the resulting inflation. Prices will rise, bond yields will rise, and the economy will go into the second phase of a double-dip recession, whether Bernanke wants it to or not.

The silver lining? Inflation will help the housing market solidify its bottom and start rising, even though interest rates will be higher.

For investors, there are two strategic investment areas, which I have mentioned before: An inverse Treasury bond fund, and exchange-traded funds (ETFs) linked to either gold or silver – clearly for use as inflationary hedges.

Let's take a look at both elements of this strategy.

The first element, the Proshares UltraShort 20-Year Treasury Fund (NYSE: TBT), is linked inversely to the Lehman Brothers 20-year Treasury Bond Index – it should rise in price by twice the amount the index falls.

These inverse exchange-traded fund ETFs have gotten bad press recently, because they need to be "rebalanced" every day and can get a huge "tracking error" if linked to a volatile index. Thus, the Chinese inverse ETF and the financial-sector inverse ETF did badly over a one-year period, even as the indexes themselves fell. However, T-bond prices are not very volatile, so the problem for TBT is much less severe.

The other investment is, of course, gold, silver or any other inflation hedge. They can be purchased through such ETFs as the SPDR Gold Trust (NYSE: GLD) and the iShares Silver Trust (NYSE: SLV).

With the economic challenges that are heading our way, these are key pieces of an investment strategy that virtually all U.S. investors need to consider.

[Editor's Note: When it comes to global investing, longtime market guru Martin Hutchinson is one of the very best - because he knows the markets firsthand. After years of advising government finance ministers, crafting deals with global investment banks, and analyzing the world's financial markets, Hutchinson has used his creative insights to create a trading service for savvy investors.

The Permanent Wealth Investor assembles high-yielding dividend stocks, profit plays on gold and specially designated "Alpha-Dog" stocks into high-income/high-return portfolios for subscribers. Hutchinson's strategy is tailor-made for periods of market uncertainty, during which investors all too often go completely to cash - only to miss some of the biggest market returns in history when market sentiment turns positive. But it can work in virtually every market environment.

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[Correction: In its mid-year forecast for the U.S. banking sector last week, Money Morning incorrectly characterized the capital buffer situation for State Street Corp. (NYSE: STT). According to State Street, "the U.S. Federal Reserve concluded that, after consolidation of the conduits and under the assumptions and methodology required by SCAP, State Street had a sufficient capital buffer to withstand even the stress test's 'more adverse' scenario." This doesn't change Money Morning's outlook for State Street. However, we regret the error.]

 

About the Author

Martin Hutchinson is the Global Investing Specialist for Money Map Press. A British-born investment banker with more than 30 years of experience, Martin has worked on both Wall Street and Fleet Street. He is now the editor of the Permanent Wealth Investor, where he focuses on "Alpha Bulldog" stocks that pay high dividends covered by earnings. In his Merchant Banker Alert, Martin uncovers the fastest-growing companies in the fastest-growing economies and brings those ideas back home to you. For more information about these services, call our VIP Services group at 855.509.6600 or 410.622.3004.

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