On August 12, 2020, the US Federal Reserve indicated that it intended to stay the course, postponing effective action that might ward off high inflation once the Obama “spending is stimulus” money hits the fan.

Non-independent Fed Chairman Ben Bernanke, running for reappointment, is not anxious to adopt strong, anti-inflationary measures that might be unpopular. The Obama administration desperately needs rising employment statistics to boost the President’s sagging popularity, while postponing the advent of inflation until after the 2010 elections.

Former Chairman Paul Volcker, renowned for his tough taming of inflation during the Reagan administration, has been neutered to a powerless position on Obama’s economic advisory board, giving the President political cover of the Volcker reputation, without substance.

Both Larry Summers and Tim Gaithner have gone on national TV to announce that Obama’s “spending is stimulus” actions would result in higher taxes. What this means is that Americans can expect to see both high levels of inflation with depressed employment (the result of higher taxes).

So, what this seems to indicate is that sometime in the future the US economy will hit a transition point when inflation will begin to kick in with a vengeance. Interest rates will soar. The value of long-term bonds will plunge. Equities will be squeezed by stagnant sales due to the continued recession and high borrowing rates.

Navigating the transition to an inflationary economy

The Federal Reserve’s record of timely action to prevent inflation is not encouraging, and barring something really dramatic (like Paul Volcker resigning from the President’s panel in protest), it seems that a transition to stagflation is in the cards.

The spread between short-term and long-term interest rates is now high and increasing. As the tipping point into inflation gets closer and closer, this differential should increase even more. In the process, holders of medium and long-term bonds will experience a loss of wealth.

At some point, long-term debt is likely to sharply fall in value. When inflation kicks in, the price of long-term bonds will stay down for a long time. Leveraged holders of medium and long-term debt will suffer severe losses.

Those who managed to take out long term mortgages on their homes at today’s bargain rates will suddenly appear to be financial wizards.

Companies that wait too long to ameliorate their over-extended positions will finding bond financing far to expensive and will have to consider raising cash by selling equity (forcing down stock prices) or by rolling-over short-term debt (forcing up short-term interest rates).

This means that rates on money market funds and short-term CD should rise as inflation hits, while prices of medium and long-term debt fall.

See: Money market funds will tell us when inflation is here.

A possible strategy for survival

If this scenario plays out in real life, the survival strategy today (August 2009) would be to get out of long-term securities (stocks and bonds) and hold quality money market funds. This means losing current income from current rates on longer term bonds and potential profits from a possible continuation of the rally in stocks.

However, history offers many examples of sudden changes in market perceptions. The question is whether the transition to inflation will be gradual, say over two or three years, or sudden — in two or three months.

For well over a year, there were many warnings of a potential crash in equity prices, but the actual event happened suddenly in September-October 2008, leaving investors with little time to exit.

See: Buyback Bubble Pops! The Long Ways Down …

Now, it may seem counterintuitive to go into cash in the expectation of inflation, since everyone knows that holding cash offers no protection against inflation. However, the logic here is somewhat different.

1. When inflation hits, it may be sudden, not affording investors a chance to get out of bonds and equities.
2. The interest rates on money market funds can be expected to rise quickly when inflation hits, perhaps exceeding the rate of inflation.
3. Once money market fund rates confirm that inflation is indeed here with a vengeance, the investor can then reassess the situation, going back into bonds or equities as may seem advisable.

If an investor holds $10,000 in a bond yielding 10% today, and the interest rate suddenly jumps to, say, 18% when inflation hits, he or she will continue to earn income of $1,000 on that bond. However, by selling the bond today and going into cash, and then reinvesting after inflation hits at 18% in the same bond, the investor’s income would now be $1,800 — 80% more than simply holding the same bond.

There are reasons to suspect that the current rally in equities may not be sustained.

See: Formidable barriers to a bear market recovery

The storm flags are flying — warning of inflation. No one knows what will happen, however since the Crash of 2008 was a precipitous event, as was the enactment of the trillion dollar stimulus packages, it seems at least reasonable that the coming of inflation will also be quick and sudden.

So the question is, if you knew that inflation was suddenly to jump to 8% next month, how would you be best invested?

On July 9, 2020, the US SEC declared California IOUs to be securities subject to Federal law, as reported in an article in The Bond Buyer.

Further regulation is expected from the Municipal Securities Rulemaking Board.

If these securities do not extend beyond one year, it would appear that they might be exempt from Federal income tax.

We would expect to hear more from the IRS on this.

The willingness of banks to accept this paper for deposit is closing down.

Classifying this issue as securities, rather than “negotiable instruments, similar to checks”, as state authorities have contended, suggests that the legality of this issue may be questioned.

This may effectively constrain California’s ability to issue these IOU’s, which were suspiciously beginning to look like money.

Shame, shame California!

You should know that only the Federal government can issue money to pay its debts.

States are supposed to be more responsible.

The theater of the absurd where US monetary policy is played out reached the height of the ridiculous when, on July 2, 2020, the Federal Reserve issued a press release advising the public to check with their banks to see the terms and conditions under which a bank may accept for deposit the “registered warrants” (IOUs) of the now insolvent State of California.

Note: the Federal Reserve did not prohibit banks from receiving California IOUs as “legal tender” for deposit, nor insist that banks, if they wished to help clients, simply buy the bills as securities, at a discount reflecting the time value of money and risk. Nor did the Federal Reserve clarify whether California IOUs on “deposit” would be subject to FDIC guarantees.

According to the Los Angeles Times, Bank of America, Wells Fargo, Chase, City National, Union Bank, and other big banks were accepting IOUs issued by the State of California for deposit.

Of course, the Federal Reserve allows banks to receive Federal IOUs (Federal Reserve Certificates, aka “money”) for deposit, so why not State of California IOUs?

Speaker Nancy Pelosi, Representative Henry Waxman, and Senator Barbara Boxer (of “don’t-call-me-ma’am” fame), representing the State of California, were silent on the matter.